the balance of payments surplus, CA is the current account surplus, and KA is the capital account surplus. IS components where E(π) is the expected rate of inflation. Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending. where Yt-1 is GDP in the previous period. Higher lagged income or a lower real interest rate leads to higher investment spending. where NX is net exports, e is the nominal exchange rate (the price of foreign currency in terms of units of the domestic currency), Y is GDP, and Y* is the combined GDP of countries that are foreign trading partners. Higher domestic income (GDP) leads to more spending on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the country's exports and thus higher net exports. A higher e leads to higher net exports. Balance of payments (BoP) components where CA is the current account and NX is net exports. That is, the current account is viewed as consisting solely of imports and exports. where is the foreign interest rate, k is the exogenous component of financial capital flows, z is the interest-sensitive component of capital flows, and the derivative of the function z is the degree of capital mobility (the effect of differences between domestic and foreign interest rates upon capital flows KA). Variables determined by the model After the subsequent equations are substituted into the first three equations above, one has a system of three equations in three unknowns, two of which are GDP and the domestic interest rate. Under flexible exchange rates, the exchange rate is the third endogenous variable while BoP is set equal to zero. In contrast, under fixed exchange rates e is exogenous and the balance of payments surplus is determined by the model. Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates, the money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply. Mechanics of the model