ABSTRACT
This chapter analyzes the simultaneous determination of prices, outputs and the exchange rate in the context of a two-country model that explicitly allows for differences in prices both within and between countries. The object of the chapter is to provide an analytical framework that generates two widely observed phenomena: output fluctuations are positively correlated internationally and the existence of substantial deviations from purchasing power parity. The chapter deals with the inference problem solved by agents located domestically and abroad and highlights the implications for expectations formation of the centralized market for foreign exchange. It discusses the nature of the solution and the implications for purchasing power parity and output fluctuations, when traders have incomplete current information on the sources of unanticipated local price movements. Thus, the device of introducing informationally distinct markets is important and necessary in order to explain departures from purchasing power parity and the generation and international transmission of business cycles.
