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230 CHAPTER 8. THE MUNDELL-FLEMING MODELconsumption, most of which is spent on domestically produced goods.Second, domestic goods demand depends negatively on the interestrate i through the investment—saving channel. Since goods prices areÞxed, the nominal interest rate is identical to the real interest rate.Higher interest rates reduce investment spending and may encourage areduction of consumption and an increase in saving. Third, demand forhome goods depends positively on the real exchange rate s+p ∗ −p. Anincrease in the real exchange rate lowers the price of domestic goodsrelative to foreign goods leading expenditures by residents of the homecountry as well as residents of the rest of the world to switch towarddomestically produced goods. We call this the expenditure switchingeffect of exchange rate ßuctuations. In equilibrium, output equals expenditureswhich is given by the IS curvey = δ(s + p ∗ − p)+γy − σi + g, (8.1)where g is an exogenous shifter which we interpret as changes in Þscalpolicy. The parameters δ, γ, and σ are deÞned to be positive with0 < γ < 1.As in the monetary model, log real money demand m d − p dependspositively on log income y and negatively on the nominal interest rate iwhich measures the opportunity cost of holding money. Since the pricelevel is Þxed, the nominal interest rate is also the real interest rate, r.In logarithms, equilibrium in the money market is represented by theLM curvem − p = φy − λi. (8.2)The country is small and takes the world price level and world interestrate as given. For simplicity, we Þx p ∗ = 0. The domestic price level isalso Þxed so we might as well set p =0.Capital is perfectly mobile across countries. 1 International capitalmarket equilibrium is given by uncovered interest parity with static1 Given the rapid pace at which international Þnancial markets are becomingintegrated, analyses under conditions of imperfect capital mobility is becoming lessrelevant. However, one can easily allow for imperfect capital mobility by modelingboth the current account and the capital account and setting the balance of paymentsto zero (the external balance constraint) as an equilibrium condition. Seethe end-of-chapter problems.