Comparing Exchange Rate Regimes and Competitiveness
Consider two small, open economies, Country A and Country B, that initially have stable prices and are equally competitive in international markets. Both countries then experience a sustained period where their domestic prices rise at a rate of 5% per year, while prices in the rest of the world rise by only 2% per year. Country A allows its currency value to be determined by market forces, while Country B maintains a fixed value for its currency against its major trading partners. Analyze the likely consequences for the international competitiveness of the goods produced by Country A versus Country B over time. In your analysis, explain the mechanism that leads to these different outcomes.
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