In Chapter 2, we described how simultaneous short-run equilibrium in the labor and goods markets could be summarized in the form of the GM curve, a relationship between the domestic price level and the domestic interest rate. To find the value of the domestic price level – and thus of the real exchange rate – that cleared the market for domestic goods, we needed to know the value of the domestic interest rate. In Chapter 3, we saw that in general, the short-run equilibrium value of the domestic interest rate itself depends on the domestic price level, through the effects of the latter on financial market equilibrium in the economy.

In this chapter we will put these two pieces of the story together to see how the domestic price level and interest rate are simultaneously determined in a general equilibrium involving the labor market, the goods market, and the financial markets. We will then explore how this short-run general macroeconomic equilibrium is affected when the economy is subjected to a variety of policy and exogenous shocks originating in various domestic markets as well as abroad. This short-run model will link the determination of intertemporal and intratemporal relative prices with domestic macroeconomic policies, as well as with the various types of exogenous shocks to which emerging economies are typically vulnerable. In the chapter that follows, we will see how the configuration of domestic macroeconomic prices evolves over time as the economy moves from a short-run to a medium-term equilibrium.