By substituting (11.72)-(11.73) and (T5.5) into (T5.3) and (T5.4), we obtain the dynamic representation of the model:

The only sign that is ambiguous in the Jacobian matrix on the right-hand side of (11.74) is the one for ae/ap. This is because an increase in the domestic price level has an ambiguous effect on the domestic interest rate. On the one hand, real money balances decrease, which leads to upward pressure on the interest rate, but on the other hand the domestic price increase also leads to a real appreciation of the exchange rate which decreases output and hence the (transactions) demand for money. This money demand effect causes downward pressure on the interest rate. We assume for simplicity that the money supply effect dominates the money demand effect, so that EmyEm < 1 and ae/ap > 0.

The model can be analysed with the aid of Figure 11.16. The e = 0 line is obtained by taking the first equation in (11.74) and solving it for e as a function of p and the exogenous variables:

e + p* = -( 1 - EMYEYQ)p — EMYEYGg M (EMR EMY YR)r* (11.75)

EMYEYQ