This paper incorporates rational expectations, full price flexibility, and currency substitution into the usual small-economy model, taking explicit account of inflation abroad. Not only will the steady-state terms of trade be affected by an increase in the rate of monetary expansion when the inflation rate abroad is assumed to be nonzero, but its dynamic path may also be different from the usual case in which inflation abroad is ignored. It has been shown that if the import demands are relatively inelastic, the terms of trade will undershoot their equilibrium value; if the import demands are elastic, the terms of trade will overshoot. The key to these diametrically opposite results is the degree of ultimate deterioration in the terms of trade, which, in turn, turn on the size of the two import demand elasticities.
