Along the p = 0 line there is full employment (y = y). It is upward sloping because an increase in the domestic price level reduces output via the real balance effect. To restore full employment, the nominal exchange rate must depreciate. For points to the right of the p = 0 line, output is below its full employment level (y < y/) and the domestic price level is falling. The opposite holds for points to the left of the p = 0 line. The dynamic forces operating on the price level are indicated by horizontal arrows in Figure 11.16. In formal terms, the second equation of (11.74) shows that the real side of the model exerts a stabilizing influence on the economy:

( ap\

=

0(EyR + EMREYR) < 0. ap EMR EMYEYQ The long-run steady-state equilibrium is at point ao in Figure 11.16, where p = e = 0 so that both r = r* and y = k hold