Exchange Rates and Perfect Competition

We consider two types of rms both operating in two countries. The demand side of the markets of the two countries are separated and each type of rm produces its good in one of these countries. We study the e ect of an exchange rate change on the competitive equilibrium prices in each country. When producing for the foreign market causes the same costs as producing for the home market then the `Law of one Price' holds and an exchange rate change is completely o set by price changes. Furthermore when cost functions are additively separable between producing for the home and producing for the foreign market then prices move in the `right' direction in response to an exchange rate change. However, with general cost structures, even in this simple competitive model, any direction of price changes can result from an exchange rate change. 1