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8.1. A STATIC MUNDELL-FLEMING MODEL 233rLMr*(1)ab(2)cFFISyy 0y 1Figure 8.2: Devaluation shifts the IS curve out. The central bankaccumulates reserves to accommodate the resulting capital inßow whichshifts the LM curve out.Fiscal policy shocks. The results of an increase in government spendingare dy =[1/(1 − γ)]dg and dm =[φ/(1 − γ)]dg which is expansionary. ⇐(137)Theincreaseing shifts the IS curve to the right and has a direct effecton expenditures. Fiscal policy works the same way as a devaluationand is said to be an effective stabilization tool under Þxed exchangerates and perfect capital mobility.Foreign interest rate shocks. An increase in the foreign interest ratehas a contractionary effect on domestic output and the money supply,dy = −(σ/(1 − γ))di ∗ ,anddm = −(λ + φσ/(1 − γ))di ∗ . The increasei ∗ creates an incipient capital outßow. To defend the exchange rate,the monetary authorities sell foreign reserves which causes the moneysupply to contract. The situation is depicted graphically in Figure 8.3.Implied International transmissions. Although we are working with thesmall-country version of the model, we can qualitatively deduce howpolicy shocks would be transmitted internationally in a two-countrymodel. If the increase in i ∗ was the result of monetary tightening inthe large foreign country, output also contracts abroad. We say that