Question

List and explain 2 things that move the DD curve to the right, and 2 things that move the DD curve to the left. Do the same for the AA curve, be sure to explain your reasoning with graphs.

Answer 1

AA curve represents the asset market equilibrium from the money market and the foreign exchange markets or it shows the combination of the exchange rate and the GNP which maintain equilibrium in the asset market. DD curve, on the other hand, represents the goods market equilibrium and is the set of combinations of the exchange rate and GNP which would maintain equilibrium in the goods market. The factors which would make the DD curve to shift right are an increase in the government demand and decrease in the taxes. The factors which would make the DD curve to shift left are the reverse of above plus the decrease in investment demand and transfer payments.

On the other hand, the AA curve will shift to the right whenever there will be an increase in the money supply or foreign interest rates. It would move or shift in the reverse direction (left) in case of opposite movements of the above factors.

So, the graphs b and c represents the shifts in the DD curve. A curve shifts whenever there is a change in the exogenous variable. So, when government expenditure increases, the economy can then produce more and raise the output and income at the same exchange rate and thus the curve shifts to the right. Similarly, with the decline in the tax rates, the consumption of the consumer increases and so is the aggregate demand and then the income level in the economy by multiplier effect, and thus shifts the DD curve to the right (Graph b), increasing the equilibrium income along with a decline in the exchange rate over time. This is because the decline in the GNP cause a decline in the interest rates making the domestic rates less preferable over the foreign interest rate shifting the finds abroad from the domestic economy and thus the currency depreciates or the exchange rate increases.

On the other hand, a decline in the investment or the transfer payments would reduce the output (former case) and the GNP which includes the transfer payments at the same exchange rate and thus the curve would shift left (graph c), over time increasing the exchange rate in the economy.

Considering the AA curve and the money market equilibrium, an increase in the supply of money would shift the AA curve to the right, and further reducing the interest rate because of higher supply than demand. The reduced domestic rates or the higher foreign rates would make the foreign currency dearer and thus there will be a movement of money to the foreign country. The reduced demand for the domestic currency would cause a depreciation of currency or the exchange rate would rise (graph d). The reverse is the case when the AA curve shifts to the left (graph a).