Along the e = 0 line the domestic interest rate equals the foreign interest rate (r = r*).

It is downward sloping in view of our assumption (made above) that EmyEm < 1.

For points above the e = 0 line the nominal (and the real) exchange rate is too high, output is too high, and the domestic rate of interest is higher than the world rate

(r > r*). Uncovered interest parity predicts that an exchange rate depreciation is expected and occurs (ee = e > 0). The opposite holds for points below the e = 0 line. These dynamic forces on the nominal exchange rate are indicated by vertical 298 299 cy. But we are really inter--

0". v this, we first reduce ir„

ven values of the nom i^ ,

..-ctic interest rate and ot.

3) and (T5.4), we obtain th.-

Chapter 11: The Open Economy Po p