Question

Suppose a country suddenly faces an unexpected but temporary fall in export demand so there is a temporary drop in current account, i.e. CA drops temporarily. The country has a fixed exchange rate for its currency. Use a DD-AA diagram to answer the following (you do not need to show the diagram, but you do need to write in words what happens on it).

a) Indicate any movement(s) of the curves on your diagram that can be observed as a result of this activity. Explain the reasons for the shift(s).

b) What happens to the exchange rate, E, as a result?

c) What happens to national income, Y, as a result?

Answer 1

The AA-DD model shows a synthesis of three market models, the foreign exchange market, the money market and the goods and services market. It has two curves, one being an AA curve which represents the asset market equilibrium which is derived from the foreign exchange and money market. The other curve is the DD curve which represents the goods market equilibrium. The point of intersection of these two curves give an equilibrium in which all the three markets are in equilibrium.

a) The current account consists of the balance of trade in goods and services along with net investment income from gforeign assets and net transfers. A deficit in the current account results from an increasing net trade deficit, in a case where the value of imports exceed the value of exports. So, in this case, as the country faces a temporary fall in export demand, there is a drop in the current account. This change in demand is translated into a movement along the DD curve. There is no shift of the DD curve. So, as the export demand is low, the country imports more than it exports. This payment of imports in done in domestic currency which is then converted in to the currency of the exporting country. So, an increase in the current acount deficit leads to an increased supply of the domestic currency in the foreign exchange market. So, there is relatively lesser demand for domestic currency, so the currency value falls. So, this currency will trade for less of other currencies meaning the exchange rate has depreciated. This shifts the AA curve downward. So, the equilibrium is pushed downwards which decreases the output/income on the horizontal axis and the exchange rate on the vertical axis. Take a look at fig 1

b) So, the exchange rate decreases.

c) The national income, Y is also decreased. Its also obvious that as exports have fallen and imports have risen, the national income of the economy will fall.