goods market equilibrium –

• Y = C(Y-T) + I(Y,r) + G – IM(Y,e)/e + X(Y*,e)
• NX = X(Y*,e) – IM(Y,e)/e
• Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*,e)
  • increase in real interest rate >> decrease in investment >> decrease in output

financial market equilibrium – same in closed and open economy

• M/P = Y L(i)
• demand for domestic money mostly among domestic residents
  • foreign residents would have to exchange money to use domestic money >> no point in them having a demand for domestic money (better off holding domestic bonds)
• interest parity condition >> i_t = i*_t - (E_t+1-E_t)/E_t
  • E = E^e (1+i) / (1+i*)
  • increase domestic interest rate >> decrease exchange rate >> appreciation of domestic currency

IS/LM model – combines financial/goods market equilibria and interest-parity

• IS: Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, E^e(1+i)/(1+i*))
  • interest rate increase >> decrease in investment, net exports >> decrease in output, demand
• LM: M/P = Y L(i)
• equilibrium interest rate determines equilibrium exchange rate