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

This paper studies how the models of the new open economy macroeconomics, which usually focus on the relationship between the nominal exchange rate and the external real exchange rate, can explain the coexistence of permanent dual inflation, namely diverging inflation rates for tradable and non-tradable goods, and appreciation of the CPI-based real exchange rate in emerging market economies.
It is shown that the impact of asymmetric sectoral productivity growth on the CPI-based real exchange rate depends heavily 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 the presence of nominal and real rigidities helps to explain the slow and incomplete adjustment of the relative price of non-tradables to tradables.