Prices and Exchange Rates: A Theory of Disconnect

where ν > 1 denotes the elasticity of substitution between varieties. As before, the set of available goods at Home ∆′ has measure N . It follows that the demand for good i is given by qi = [pi P ]−ν Q, where pi is the price of good i, and P = [∫ i∈∆′ p 1−ν i di ] 1 1−ν is the price of the aggregate consumption good Q. The total consumption expenditure of the representative Home household is given by I = PQ. Recall that households are located in the unit interval, so that household demand and market demand are equal. Assuming that the marginal cost of producer i is constant and given by mci, its profit maximizing price is given by pi = (1 + μ)mci, where the markup over marginal cost is constant and equal to μ = 1 ν − 1 . (B-2)