where we have used the fact that dr = dr* due to perfect capital mobility. By comparing

(T2.1) and (11.45), it is clear that the IS curve is augmented in a number of ways. First, the interest rate exerts a stronger effect on domestic production than before. The reason is that changes in the interest rate decrease investment in both countries, and since some investment goods are imported, spillover effects exist.

Second, foreign government spending spills over into the domestic economy, both directly (via the term involving G*) and indirectly (via the term with Y*).

Of course, the foreign country also has an IS curve (labelled IS*) which is similar in form to (11.45). By making the appropriate substitutions, the IS* curve can be written as:

—wIE1R dr* + wG [( 1 — wx)G* + wx + wxwcEcyk 1 — (1 — wx)(ocEcy

[(1 — wx)(1 — a)+wxa) Q 1 — (1 — wx)wcEcY

(11.46)