In recent times, international financial markets have been subject to a high degree of volatility, which produces cascading effect in employment and output. Naturally, it is important to analyze the link between the real sector and the financial sector. Towards this end, we construct an open economy model based on effective demand principle. At the heart of the model is the link between net capital flows, exchange rate, Tobin’s q and domestic investment. The paper shows that an adverse financial shock can lead to contraction of the real sector through change in asset prices, namely exchange rate and Tobin’s q.