DSE 2012 Question 59: Open-economy macroeconomics

Let us now bring in an asset market and a foreign exchange market. The asset market equilibrium (LM) is $\overline{M}=l_{1}Y-l_{2}r$. The foreign exchange market equilibrium is the interest parity condition $r=r^{*}+\dfrac{1}{\varepsilon}(\varepsilon^{e}-\varepsilon)$, with $r^{*}$ the foreign interest rate and $\varepsilon^{e}$ the expected future exchange rate. For given $r^{*}$ and $\varepsilon^{e}$, derive the level of output that clears both the asset market and the foreign exchange market as a function of the real exchange rate $\varepsilon$. Plotting $Y$ against $\varepsilon$ (with $\varepsilon$ on the vertical axis), you will get