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232 CHAPTER 8. THE MUNDELL-FLEMING MODELThe situation is depicted graphically in Figure 8.1. First, the expansionof domestic credit shifts the LM curve out. To maintain interestparity there is an incipient capital outßow. The central bank defendsthe exchange rate by selling reserves. This loss of reserves causes theLM curve to shift back to its original position.rr*LM(1)(2)aFFbISyy 0Figure 8.1: Domestic credit expansion shifts the LM curve out. Thecentral bank loses reserves to accommodate the resulting capital outßowwhich shifts the LM curve back in.(136)⇒Domestic currency devaluation. From (8.4)-(8.5), you havedy =[δ/(1−γ)]ds > 0anddm =[φδ/(1 −γ)]ds > 0. The expansionaryeffects of a devaluation are shown in Figure 8.2. The devaluation makesdomestic goods more competitive and expenditures switch towards domesticgoods. This has a direct effect on aggregate expenditures. In aclosed economy, the expansion would lead to an increase in the interestrate but in the open economy under perfect capital mobility, theexpansion generates a capital inßow. To maintain the new exchangerate, the central bank accommodates the capital ßows by accumulatingforeign exchange reserves with the result that the LM curve shifts out.One feature that the model misses is that in real world economies,the country’s foreign debt is typically denominated in the foreign currencyso the devaluation increases the country’s real foreign debt burden.