S TAGFLATION AND T OPSY -T URVY C APITAL F

(14) indicates that the effects of an appreciated terms of trade on the trade balance depends on the relative importance of the elasticity of substitution across goods (η) and the intertemporal elasticity of substitution, which is set to one. [...] The real marginal cost (measured in units of the domestic good) depends positively on the marginal rate of substitution between consumption and leisure and negatively on the terms of trade.10 However, since the equilibrium marginal rate of substitution itself depends ambiguously on the terms of trade (for given levels of output and the demand imbalance), the relationship between the terms of trade. [...] On the one hand, the stronger the home bias, the more changes in relative spending affect the relative price between Home and Foreign good.20 On the other hand, the larger the trade elasticity, the smaller are price movements associated to a given change in relative spending. [...] As alluded to earlier, the most plausible model calibrations place us in the area above the Cole-Obstfeld line, where capital inflows into the most depressed country are excessive and topsy-turvy 23Since each country’s output gap is proportional to the policymaker’s co-state on the NKPCs, the most depressed country also happens to be the one for which relaxing the NKPC is the most valuable to the. [...] The phase diagram shows that optimal CFM results in a more favorable trade-off between the stabilization of the cross-country difference in the output gap and the cross-country difference in domestic inflation, regardless of the direction of the inefficiency.