The DD-AA Model
ECON3236 International Finance
Girish Bahal
Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 499-504
(Output and the Exchange Rate in the Short Run)
Learning Objectives
Understand ...
(cid:73)
How the AA schedule represents the equilibrium in the asset markets
(cid:73)
How the intersection of the DD and AA schedules characterizes an open
economy’s short-run equilibrium
The AA schedule: Equilibrium in the asset markets
The AA schedule is all combinations of E and Y that are consistent with
equilibrium in the domestic money market and the foreign exchange market
Equilibrium in the FX market:
R =R∗+(Ee −E)/E
R, in turn, is determined by the equilibrium in the domestic money market:
MS/P =L(R,Y)
The AA schedule: Equilibrium in the asset markets
If, in the short run, output ↑ from Y1
to Y2
The real money demand ↑ from
L(R,Y1) to L(R,Y2)
With real money supply fixed
Equilibrium interest rate ↑ from R1 to
R2
The AA schedule: Equilibrium in the asset markets
The new equilibrium in the FX market
is at E2
Hence, E ↓ as Y ↑ (and vice-versa)
→ AA curve slopes downward in the
E-Y graph
The AA schedule: Equilibrium in the asset markets
The AA schedule slopes downwards:
(cid:73) As output ↑ from Y1 to Y2
(cid:73)
R ↑ and domestic currency
appreciates from E1 to E2
The AA schedule: Equilibrium in the asset markets
As Ms ↑: home currency depreciates
(E ↑) for any given Y → AA shifts up
As real money demand ↑: R ↑ → E ↓
for any given Y → AA shifts down
As P ↑: real money supply ↓ → R ↑;
E ↓ for any given Y → AA shifts down
The AA schedule: Equilibrium in the asset markets
As Ee ↑: home currency is expected to
depreciate more sharply in future
E ↑ for any given Y → AA shifts up
As R∗ ↑: → the return on foreign
currency assets ↑
E ↑ for any given Y → AA shifts up
The short run equilibrium
The short run equilibrium
If the economy is at point 2, E is very
high
$ is expected to appreciate at a rate
greater than the rate that satisfies UIP
return on foreign assets < return on
domestic assets
→ demand for home assets ↑ → home
currency appreciates immediately to E3
The short run equilibrium
At point 3, both asset markets are in
equilibrium
Given Y, E is still too high; there is
excess demand for domestic goods
Firms ↑ production to avoid depleting
their inventories → Y starts to increase
Y continues to ↑ till economy reaches
point 1
The short run equilibrium
Asset prices can adjust immediately but
changes in Y take time
Hence asset markets remain in
equilibrium even while Y is changing
The exchange rate falls as the economy
approaches point 1 along AA. Why?
The short run equilibrium
Rising output → money demand to ↑
→ the interest rate steadily ↑
→ $ appreciates steadily to lower the
expected rate of future $ appreciation
and maintain UIP
