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We would like to thank Mohsin Khan for his comments on an earlier draft. Remaining errors are our responsibility.
In the absence of terms of trade shocks, π* is the foreign currency rate of inflation of traded goods, which will be referred to in what follows simply as the foreign inflation rate.
We have suppressed the real exchange rate as an argument from the supply of nontradables function since, under the real exchange rate rule, this relative price does not change.
The instability of the system defined by
Our comparative statics result with respect to inflation do not, however, depend on the assumption that the SS schedule is negatively sloped. If the slope of SS is positive, then the result requires only that SS be steeper than NN, which is assured by previous assumptions.
The fact that
Again, our comparative statics results do not depend on this assumption.
Notice that this condition is equivalent to the requirement that the product of the share of seignorage in real income and the income elasticity of money demand be less than unity, something that would be easily satisfied for any plausible values of the parameters.
By contrast, under a fixed exchange-rate regime, this shock would lead to a real exchange-rate appreciation in the model, with no change in the steady-state rate of inflation (see Khan and Montiel (1987)).
In this case,
Recall the assumption i* = π*.
If the central bank extends credit to the government, m-dP is reserves plus credit to the government; in either case, m-dP is positive.
As mentioned previously, all results are evaluated around an initial steady state with b=1.
We assume that the
This can be shown as follows. Totally differentiating equation (5) under the assumption of perfect capital mobility so that b=1 (and therefore
Since m+w cannot jump at the moment that controls are abandoned, equation (5) implies that b also cannot change discontinuously.