In Chapter 5, we analyzed how aggregate supply and demand interact to determine the equilibrium value of the domestic price level and the level of real output. To find the equilibrium values of these variables, however, we needed to know the value of the domestic interest rate. In that chapter, we assumed that the central bank simply set the value of the domestic interest rate as a policy variable, without specifying how it managed to do so. In Chapter 6, on the other hand, we saw that in general – that is, when the central bank is not explicitly targeting the interest rate – the short-run equilibrium value of the domestic interest rate itself depends on the domestic price level, through the effects of changes in the domestic price level on equilibrium in the domestic bond market. In Chapter 6, we took the domestic price level as an exogenous influence on the domestic bond market, without specifying how the price level was itself determined.

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. To understand how the model works, we will make use of the goods-market equilibrium curve GM from Chapter 5 and the domestic bond-market equilibrium curve BB from Chapter 6.