EC311: International Economics

The DD-AA Model

Dr. Hussein Hassan

Email: Hussein.Hassan@reading.ac.uk
Office Hours: Wednesday 10-12pm and Friday 10-11am
Room: EM289

Spring 2020/21

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Goods Market in an Open Economy

The demand for domestic goods in an open economy can be represented

by the following equation:

Where, is consumption, is investment, is government spending and is

current account (or net exports) which is equal to exports minus imports
. Consumption depends positively on disposable income , where is taxes.
Investment and government spending are assumed here to be exogenous.
Nest exports depend positively on real exchange rate and negatively on
disposable income.

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Goods Market in an Open Economy

Real exchange rate is calculated as follows:

Where, is the nominal exchange rate which is defined here as the

amount of domestic currency per one unit of foreign currency, is the
foreign price level and is the domestic price level. Note here that:

1. A devaluation of the domestic currency is an increase in the price of

the foreign currency in terms of domestic currency. Given our
definition of exchange rate, a devaluation here means an increase in
the exchange rate.

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Goods Market in an Open Economy

2. An appreciation of the domestic currency is a decrease in the price of

the foreign currency in terms of domestic currency. Given our
definition of exchange rate, an appreciation here means a decrease in
the exchange rate.

3. By assuming that the price levels at home country and abroad are
fixed, thus real exchange rate is proportional to nominal exchange
rate. That is when the domestic currency depreciates, both nominal
and real exchange rates rise. Thus, domestic goods become more
cheaper compared to foreign goods which causes exports to increase
and imports to decrease.

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Goods Market in an Open Economy

The goods market is in equilibrium when output equals the demand as

follows:

Graphically, equilibrium in goods

market occurs at the intersection
point between the aggregate
demand and the aggregate supply
curves at point 1.

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Goods Market in an Open Economy

 An increase in nominal
exchange rate from to , with
fixed domestic and foreign price
levels, devaluates real exchange
rate.

 As a result, net exports and

then the aggregate demand
increase. The aggregate demand
curve shifts up and the
equilibrium output level
increases from to .
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Goods Market in an Open Economy – DD Curve

 The DD curve illustrates the

positive relationship between
output and the exchange rate.

 Graphically, this positive

relationship can be drawn by an
upward sloping curve showing
that when nominal (and then
real) exchange rate increases,
both aggregate demand and
output rise.

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Shifting the DD Curve

Changes in the exchange rate cause

movements along a DD curve.
Other changes cause it to shift as
follows:

 Changes in G: more government

purchases cause higher
aggregate demand and output in
equilibrium. Output increases
for every exchange rate: the DD
curve shifts right.

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Shifting the DD Curve

 Changes in T: lower taxes rises consumption, demand and

output in equilibrium for every exchange rate: the DD curve
shifts right.

 Changes in I: higher investment expenditure is represented by

shifting the DD curve right.

 Changes in P relative to P*: lower domestic prices relative to

foreign prices are represented by shifting the DD curve right.

 Changes in C: willingness to consume more and save less is

represented by shifting the DD curve right.

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Asset Market

We consider two asset markets in determining the asset market

equilibrium. These are:

1. Foreign exchange market which in equilibrium is represented by the

following condition(i.e. Uncovered Interest Parity (UIP) Condition ) :

Where,

is the domestic interest rate, is the foreign interest rate, is the

expected exchange rate and is the current exchange rate.

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Asset Market

2. Money market which is in equilibrium when real money demand

equals real money supply as follows:

Where,

is the interest rate which affects money demand negatively and is

real income which affects money demand positively.

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Asset Market

 The money market equilibrium

condition is represented graphically in
this figure. Real money is measured on
the horizontal axis and the interest rate
is measured on the vertical axis.

 An increase in real income increases

the demand for money and shifts the
money demand curve to the rightThe
equilibrium interest increases.

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Asset Market – AA Curve

 Increasing real income (output), increases money demand which

leads to a higher domestic interest rate. Higher domestic interest rate
leads to an appreciation of the domestic currency (i.e. recall that an
appreciation of the domestic currency is represented by a fall in E).
When real income and production decrease, the domestic currency
depreciates and E rises.

 This inverse relationship between output and exchange rates needed

to keep the foreign exchange markets and the money market in
equilibrium is known by the AA curve.

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Asset Market – AA Curve

 The AA curve illustrates the

negative relationship between
output and the exchange rate.

 Graphically, this negative

relationship can be drawn by a
downward sloping curve
showing that when nominal
(and then real) exchange rate
increases, output falls.

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Shifting the AA Curve

 Changes in : An increase in the money supply reduces interest rates in

the short run, causing the domestic currency to depreciate (a rise in E)
for every Y: the AA curve shifts up (right).

 Changes in P: An increase in the level of average domestic prices

decreases the supply of real monetary assets, increasing interest rates,
causing the domestic currency to appreciate (a fall in E): the AA curve
shifts down (left).

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Shifting the AA Curve

 Changes in R*: An increase in the foreign interest rates makes foreign

currency deposits more attractive, leading to a depreciation of the
domestic currency (a rise in E): the AA curve shifts up (right).

 Changes in : if market participants expect the domestic currency to

depreciate in the future, foreign currency deposits become more
attractive, causing the domestic currency to depreciate (a rise in E):
the AA curve shifts up (right).

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The DD-AA Model

The intersection point between the

AA and DD curves determines the
short-run equilibrium values for
nominal exchange rate and real
output in both goods and asset
markets. At equilibrium:

1. Aggregate demand equals to

aggregate output.

2. The UIP condition holds.

3. Real money demand equals to

real money supply.
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The DD-AA Model and Monetary Expansion

 An increase in the quantity of

money supplied lowers interest
rates in the short run, causing
the domestic currency to
depreciate (E rises).

 The AA shifts up. Domestic

products relative to foreign
products are cheaper, so that
aggregate demand and output
increase until a new short-run
equilibrium is achieved.
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The DD-AA Model and Fiscal Expansion

 An increase in government
spending or a decrease in taxes
increases aggregate demand and
output in the short run.

 The DD curve shifts right.

Higher output increases the real
demand for money which
increases interest rates, causing
the domestic currency to
appreciate (E falls).

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Macroeconomic Policies and Current Account

 By applying an expansionary fiscal or monetary policy, we have seen

that real output (income) increases. By increasing real income,
imports increase and the current account (net exports) decreases as
people will be importing more and more, when other factors remain
constant.

 To keep the current account at its desired level, the domestic

currency must depreciate (i.e. E rises) as income from production
increases. This positive relationship is represented using an upward
sloping curve known by XX.

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Macroeconomic Policies and Current Account

 The XX curve slopes upward

but is flatter than the DD curve.

 As domestic income increases,

the domestic currency must
depreciate to encourage
foreigners to increase their
demand of domestic products in
order to keep the current
account at its desired level—on
the XX curve at the fixed
exchange rate .
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