Question

Using the AA-DD diagram, briefly explain how output and exchange rate will change with a temporary:

a. increase in money supply

b. fiscal expansion.

Answer 1

Scenario 1 - Increase in Money Supply

At the onset, it is important to note that the AA curve represents the market equilibrium that is derived from money markets and exchange rates. On the other hand, the DD curve represents the market equilibrium that is derived from the goods and services markets.

The chart below gives the AA-DD diagram with an increase in money supply followed by explanation.

The initial equilibrium is given by the AA and DD curve with GNP at Y1 and exchange rate at E1. When the money supply increases, the AA curve shifts to the right and the new curve is represented by A1A1. This translates into an increase in GNP from Y1 to Y2. At the same time, the exchange rate increases from E1 to E2. In other words, the home currency (Dollar) depreciates against the British Pound.

Therefore, the overall result in an increase in GNP and decline in the value of dollar as a result of an increase in money supply.

Scenario 2 - Expansionary Fiscal Policy

When expansionary fiscal policy is pursued by the government, the tax rate declines. This translates into higher disposable income and higher consumption spending by the households. At the same time, when government spending increases on infrastructure or defense, the result in higher output, higher consumption and job creation. The impact of expansionary fiscal policy is therefore on the DD curve, which shifts to the right as consumption of goods and services in the economy increases. This is shown in the chart below.

The initial curves are given as AA and DD with equilibrium GNP at Y1 and exchange rate at E1. When the DD curve shifts to the right to D1D1, the GNP increases from Y1 to Y2. At the same time, the exchange rate declines from E1 to E2. Therefore, the home currency (Dollar) appreciates against the British Pound as demand for goods and services increases in the economy.