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8.4. VAR ANALYSIS OF MUNDELL—FLEMING 261Problems1. (Static Mundell-Fleming with imperfect capital mobility). Let thetrade balance be given by α(s + p ∗ − p) − ψy. A real depreciationraises exports and raises the trade balance whereas an increase inincome leads to higher imports which lowers the trade balance. Letthe capital account be given by θ(i−i ∗ ), where 0 < θ < ∞ indexes thedegree of capital mobility. We replace (8.3) with the external balanceconditionα(s + p ∗ − p) − ψy + θ(i − i ∗ )=0,that the balance of payments is 0. (We are ignoring the service account.)When capital is completely immobile, θ = 0 and the balance ofpayments reduces to the trade balance. Under perfect capital mobility,θ = ∞ implies i = i ∗ which is (8.3).(a) Call the external balance condition the FF curve. Draw the FFcurve in r, y space along with the LM and IS curves.(b) Repeat the comparative statics experiments covered in this chapterusing the modiÞed external balance condition. Are any of theresults sensitive to the degree of capital mobility? In particular,how do the results depend on the slope of the FF curve in relationto the LM curve?2. How would the Mundell-Fleming model with perfect capital mobilityexplain the international co-movements of macroeconomic variables inChapter 5?3. Consider the Dornbusch model.(a) What is the instantaneous effect on the exchange rate of a shockto aggregate demand? Why does an aggregate demand shocknot produce overshooting?(b) Suppose output can change in the short run by replacing the IScurve (8.7) with y = δ(s − p) +γy − σi + g, replace the priceadjustment rule (8.8) with úp = π(y−ȳ), where long-run output isgiven by ȳ = δ(¯s − ¯p)+γȳ − σi ∗ + g. Under what circumstancesis the overshooting result (in response to a change in money)robust?