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236 CHAPTER 8. THE MUNDELL-FLEMING MODELr(1)LM(2)r*FFy 0ISyFigure 8.5: Expansionary Þscal policy shifts IS curve out. Incipientcapital inßow generates an appreciation which shifts the IS curve backto its original position.version of crowding out. Recipients of government spending expand atthe expense of the traded goods sector.Interest rate shocks. An increase in the foreign interest rate leads to anincipient capital outßow and a depreciation given byds =[(λ(1 − γ) +σφ)/φδ]di ∗ > 0. The expenditure-switching effectof the depreciation causes the IS curve in Figure 8.6 to shift out. Theexpansionary effect of the depreciation more than offsets the contractionaryeffect of the higher interest rate resulting in an expansion ofoutput dy =(λ/φ)di ∗ > 0.International transmission effects. If the interest rate shock was causedby a contraction in foreign money, the expansion of domestic outputwouldbeassociatedwithacontractionofforeignoutputandmonetarypolicy shocks are negatively transmitted from one country to anotherunder ßexible exchange rates. Government spending, on the other handis positively transmitted. If the increase in the foreign interest rate wasprecipitated by an expansion of foreign government spending, we wouldobserve expansion in output both abroad and at home.