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8.3. A STOCHASTIC MUNDELL—FLEMING MODEL 241tals even when agents have perfect foresight. The implied dynamics areillustrated in Figure 8.7.If there were instantaneous adjustment (π = ∞), we would immediatelygo to the long run and would continuously be in equilibrium. Solong as π < ∞, the goods market spends some time in disequilibriumand the economy-wide adjustment to the long-run equilibrium occursgradually. The transition paths, which we did not solve for explicitlybut is treated in the chapter appendix, describe the disequilibrium dynamics.It is in comparison to the ßexible-price (long-run) equilibriumthat the transitional values are viewed to be in disequilibrium.There is no overshooting nor associated excess volatility in responseto Þscal policy shocks. You are invited to explore this further in theend-of-chapter problems.8.3 A Stochastic Mundell—Fleming ModelLet’s extend the Mundell-Fleming model to a stochastic environmentfollowing Obstfeld [111]. Let ytd be aggregate demand, s t be the nominalexchange rate, p t be the domestic price level, i t be the domesticnominal interest rate, m t be the nominal money stock, and E t (X t )bethe mathematical expectation of the random variable X t conditionedon date—t information. All variables except interest rates are in naturallogarithms. Foreign variables are taken as given so without loss ofgenerality we set p ∗ =0andi ∗ =0.The IS curve in the stochastic Mundell-Fleming model isy d t = η(s t − p t ) − σ[i t − E t (p t+1 − p t )] + d t , (8.17)where d t is an aggregate demand shock and i t − E t (p t+1 − p t )istheexante real interest rate. The LM curve ism t − p t = y d t − λi t, (8.18)where the income elasticity of money demand is assumed to be 1. Capitalmarket equilibrium is given by uncovered interest parityi t − i ∗ = E t (s t+1 − s t ). (8.19)