Dual Inflation and the Real Exchange Rate in New Open Economy Macroeconomics

Abstract

This paper studies how the models of the new open economy macroeconomics, which usually focuses on the relationship between the nominal exchange rate and the external real exchange rate, can explain the coexistence of permanent dual inflation, i.e. diverging inflation rates for tradable and non-tradable goods, and real appreciation in emerging market economies. It is shown that the impact of asymmetric sectoral productivity growth on the real exchange rate heavily depends on the market structure, and that the models of new open economy macroeconomics can be reconciled with the Balassa - Samuelson effect only if pricing to market is added to models. It is demonstrated that in the presence of nominal rigidities and investments adjustment costs firms’ marginal cost is influenced by demand factors even if technology exhibits constant returns to scale. As a consequence, the effect of asymmetric productivity growth becomes weaker. Furthermore, in this case alternative factors can influence dual inflation as well. But according to the numerical simulations, these factors hardly explain the empirically observable dual inflation and real appreciation by themselves without asymmetric productivity growth. Keywords: dual inflation, real exchange rate, new open economy macroeconomics, Balassa - Samuelson effect.