Construct the phase diagram for the system (L.s)-(L.p). Assume that .
What does this assumption mean?
Next, the reader is asked to verify that the steady state of the system is a saddle point. As we saw in Chapter 10, this implies that the system converges to the steady state provided its initial position lies on a straight line through this point, called the convergent subspace of the system or saddle path. For a given initial value of the domestic price level (which we take to be a predetermined variable) there is a unique value of the exchange rate that will put us on this convergent trajectory. Because any other solution of the system would "explode," generating a rather unreasonable trajectory of domestic prices and exchange rates, we will take the saddle path as the equilibrium solution of the model. The reader is asked to solve explicitly for the appropiate particular solution of the dynamical system