Real Shocks Unemployment and the Equilibrium Real Exchange Rate

We develop a model of exogenous shocks on the real exchange rate between two large countries. We alter the model by introducing unemployment to consider the issue of how unemployment in a country can significantly change the effects of real shocks on the exchange rate. Introducing unemployment adds flexibility in production that can alter the magnitudes and even signs of shocks to the real exchange rate. These changes occur because of intersectoral differences in labor demand elasticities, as well as from differences between consumption shares in the two sectors. We explore the comparative statics demonstrating the various real shock effects on the exchange rate in the presence of unemployment. A few policy implications are drawn from the comparative statics results.