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248 CHAPTER 8. THE MUNDELL-FLEMING MODEL(142)⇒Using the deÞnition of α and (8.27) to eliminate (y t −d t )/η, rewrite thesolution in terms of ˜q t and news(1 + λ)(1 − θ)q t =˜q t +η + σ + λ [v t − z t + αδ t ]. (8.42)Nominal shocks have an effect on the real exchange rate due to the rigidityin price adjustment. Disequilibrium adjustment in the real exchangerate runs in the opposite direction of price level adjustment. Monetaryshocks and demand shocks cause the real exchange rate to temporarilyrise above its equilibrium value whereas supply shocks cause the realexchange rate to temporarily fall below its equilibrium value.To get the nominal exchange rate s t = q t + p t , add the solutions forq t and p t(1 − θ)s t =˜s t +(1− η − σ)(η + σ + λ) [v t − z t + αδ t ]. (8.43)The solution displays a modiÞed form of exchange-rate overshootingunder the presumption that η + σ < 1 in that a monetary shock causesthe exchange rate to rise above its shadow value ˜s t . In contrast tothe Dornbusch model, both nominal and real shocks generate modiÞedexchange-rate overshooting. Positive demand shocks cause s t to riseabove ˜s t whereas supply shocks cause s t to fall below ˜s t .To determine excess goods demand, you know that aggregate demandisyt d = ηq t − σE t (∆q t+1 )+d t .Taking expectations of (8.42) yieldsE t (∆q t+1 )=γη + σ δ (1 + λ)(1 − θ)t −(η + σ + λ) [v t − z t + αδ t ].Substitute this and q t from (8.42) back into aggregate demand andrearrange to getyt d = y (1 + λ)(1 − θ)(η + σ)t + [v t − z t + αδ t ]. (8.44)(η + σ + λ)Goods market disequilibrium is proportional to the news v t − z t + αδ t .Monetary shocks have a short-run effect on aggregate demand, whichis the stochastic counterpart to the statement that monetary policy isan effective stabilization tool under ßexible exchange rates.