Question

Assume the output market adjusts more rapidly than the asset market. A point of disequilibrium that is below both AA and DD will therefore initially result in

A) an increase in output.
B) a decrease in output.
C) a contraction of the money supply.
D) a depreciation of the home currency.
E) an appreciation of the home currency.

The correct answer is B, but why?

Answer 1

AA and DD model combines the workings of the money i.e. ,it is related to foreign markets and goods & services into one model.

Generally, there can be quick adjustments in the asset market and slowly in goods & services market but here we have assumed there is output market rapidly adjusts.

Now, here is the situation of disequilibrium point below AA and DD curve which initially result in decrease in output because of the following reasons:

i.) decrease in foreign prices

ii.) increase in taxes

iii.) decrease in transfer payments

iv.) increase in government demands

v.) decrease in money supply

vi.) Increase in prices

vii.) decrease in foreign interest rates or exchange rates

Due to these changes, DD curve shifts to the left and AA curve downwards and that results in decrease in output.

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