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238 CHAPTER 8. THE MUNDELL-FLEMING MODELexchange rate s + p ∗ − p, realincomey, andtheinterestratei 3y d = δ(s − p)+γy − σi + g, (8.7)wherewehavesetp ∗ =0.Denote the time derivative of a function x of time with a “dot”úx(t) =dx(t)/dt. Price level dynamics are governed by the ruleúp = π(y d − y), (8.8)where the parameter 0 < π < ∞ indexes the speed of goods marketadjustment. 4 (8.8) says that the rate of inßation is proportional toexcess demand for goods. Because excess demand is always Þnite, therate of change in goods prices is always Þnite so there are no jumps inprice level. If the price level cannot jump, then at any point in time itis instantaneously Þxed. The adjustment of the price-level towards itslong-run value must occur over time and it is in this sense that goodsprices are sticky in the Dornbusch model.International capital market equilibrium is given by the uncoveredinterest parity conditioni = i ∗ + ús e , (8.9)where ús e is the expected instantaneous depreciation rate. Let ¯s bethe steady-state nominal exchange rate. The model is completed byspecifying the forward—looking expectationsús e = θ(¯s − s). (8.10)Market participants believe that the instantaneous depreciation is proportionalto the gap between the current exchange rate and its long-runvalue but to be model consistent, agents must have perfect foresight.This means that the factor of proportionality θ must be chosen to beconsistent with values of the other parameters of the model. This perfectforesight value of θ can be solved for directly, (as in the chapter3 Making demand depend on the real interest rate results in the same qualitativeconclusions, but messier algebra.4 Low values of π indicate slow adjustment. Letting π → ∞ allows goodsprices to adjust instantaneously which allows the goods market to be in continuousequilibrium.