The US produces apples and Germany produces bananas. The nominal exchange rate in the US is 1.1.
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Question:
What is the long-run real exchange rate in absence of trade barriers and home biases?
Continue from the previous question. But now countries are biased toward their domestic output. The US CPI is composed as
P = Pa^0.75 * Pb^0.25
and the German CPI is
P* = P*a^0.5 * P*b^0.5
Set up the US real exchange rate formula in terms of the US price level P and the German price level P*. Simplify it so that it is in terms of US prices of bananas and apples and solve for the US real exchange rate under home bias.
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