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6. Consider a version of the Dornbusch (1976) model of exchange rates.
m - p(t) = -i(t)
i(t) = i* + e(t)
p (t) = e(t) - p(t)
where m is the log money stock, p(t) is the log price level, i(t) is the domestic nominal
interest rate, and e(t) is the log exchange rate. The foreign price level is fixed at p* = 0.
Suppose we are in a steady state. Then, the &quot;foreign&quot; country suddenly and permanently
increases its nominal interest rate, i.e. i* goes up.
(a) Explain what happens to the exchange rate and the price level in the short and the
long run.
(b) Define the real exchange rate. What happens to it in the short and the long run?
(c) Define the real interest rate. What happens to it in the short and the long run?
3

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