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# Theoretical framework

Benchmark model

The model consists of a real sector and a monetary sector, where the Phillips curve and aggregate demand for goods constitute the real sector, and the money and the international asset markets constitute the monetary sector. All variables, except the interest rates, are in natural logarithms and Greek letters denote positive structural parameters. The Phillips curve is (1)

where dp/dt, y d, y denote the inflation rate, aggregate demand for goods and aggregate supply of goods, respectively. Goods prices respond to market disequilibria, but not fast enough to eliminate the disequilibria instantly. Two extremes are obtained by letting α --> ∞, which is the case of perfectly flexible prices, and by setting α = 0, which is the case of completely rigid prices. Aggregate demand for goods is

y d = β(s-p) + γy (2)

where s and p denote the spot exchange rate and the price level, respectively. The exchange rate is defined as the amount of the domestic currency one has to pay for one unit of the foreign currency. The first term in eq. (2) represents net exports which depend on the real exchange rate, s - p. The second term represents income-dependent demand for goods.

Eq. (3) constitutes the money market:

m = p + δy - ζi (3)

where m and i denote the money supply and the interest rate, respectively. The real money demand, m-p, depends on aggregate income and the interest rate. The money market is assumed to be in permanent equilibrium, i.e., disturbances are immediately intercepted by a perfectly flexible interest rate. Eq. (4) constitutes the international asset market: (4)

where i* and E(ds/dt) denote the foreign interest rate and the expected rate of change of the exchange rate, respectively. This asset market equilibrium condition, also known as uncovered interest parity, is based on the assumption that domestic and foreign assets are perfect substitutes. The equilibrium condition is maintained by the assumption of a perfectly flexible exchange rate.