Question

This question puts together all that we have learned so far. Imagine that you have just been hired as an economist by the government, and you have been asked to “create” a model that combines the goods and market service with the Asset market. We are interested in determining the relationship between output and the exchange rate. This relationship should be represented in the space with output in the horizontal axis and the exchange rate on the vertical axis, i.e. the (Y,S) space.

Assume the curve describing the goods and market services is called DD and the one describing the asset market is called the AA curve.

A) Show how you would go about deriving these curves and explain why the curves are upward or downward sloping.

Answer 1

Answer: The AA-DD model represents a synthesis of the three market models: the foreign exchange (Forex) market, the money market, and the goods and services market.

The AA-DD model is described consists of two curves : an AA curve which represents asset market equilibrium derived from the money market and foreign exchange markets and a DD curve which represents goods market (or demand) equilibrium. The intersection of the two curves identifies a market equilibrium in which each of the three markets is simultaneously in equilibrium. Therefore, we refer this equilibrium as a super equilibrium.

Derivation of DD curve

The DD curve is derived by transferring information described in the goods and services (G&S) market model to show the relationship between the exchange rate and equilibrium gross national product (GNP).

The aggregate demand (AD) function with respect to changes in U.S. GNP (Y_$) is shown in the below figure. Aggregate demand is measured along the vertical axis and aggregate supply (or the GNP) is measured on the horizontal axis.

The AD function depends upon several different exogenous variables i.e. the exchange rate between domestic and foreign currency (E_$/£). The other factors affecting AD are investment demand (I), government demand (G), government tax revenues (T), government transfer payments (TR), and the price level in the domestic (P_$) and foreign (P_£) countries. The endogenous variable described in the model is the U.S. GNP (Y_$).

Graphical Derivation of DD Curve:

The DD curve as shown in the above graph plots an equilibrium GNP level for every possible exchange rate that may prevail in the economy. Higher exchange rate needs larger output in order to keep the output market in equilibrium therefore, DD schedule slopes upward.

Derivation of AA curve

The AA curve is derived by transferring information described in the money market and foreign exchange market models to show the relationship between the exchange rate and equilibrium GNP.

The foreign exchange market, depicted in the below figure plots the rates of return on domestic U.S. assets (RoR_$) and foreign British assets (RoR_£). The asset market equilibrium consists of various exogenous variables that determine the positions of the curves and the outcome of the model. These are the U.S. money supply (M_$^S) and domestic U.S. price level (P_$), which influence real money supply; the foreign British interest rate (i_£) and the expected future exchange rate (E_$/£^e), which influence the foreign British rate of return (RoR_£); and U.S. GNP (Y_$), which influences real money demand. On the other hand, domestic interest rates (i_$) and the exchange rate (E_$/£) are the endogenous variables in the asset model.

Graphical Derivation of AA Curve:

Larger output needs higher interest rate in order to keep the money market in equilibrium, and higher interest rate needs lower exchange rate in order to keep the Forex market in equilibrium therefore, the AA schedule slopes downward.