Real Interest Rates and Home Goods: A Two-Period Model*

Using a simple model of a small open economy which includes traded and non-traded goods and output in two periods, we demonstrate that changes in real interest rates will be associated with changes in real exchange rates. A high real interest rate will encourage consumers to substitute away from present and toward future consumption. To transfer consumption of non-traded goods intertemporally, intersectoral resource flows are required In the simplest model, this in turn requires opposite movements in the real exchange rate over two periods.