International Finance Theory and Policy
by Steven M. Suranovic

Finance 60-0

# The AA-DD Model: Overview

This section describes the derivation and the mechanics of the AA-DD model. The AA-DD model represents a synthesis of the three previous market models: the foreign exchange market, the money market and the goods and services market. In a sense, there is really very little new information presented here. Instead, the chapter provides a graphical approach to integrate the results from the three models and to show their interconnectedness. However, because so much is going on simultaneously, working with the AA-DD model can be quite challenging.

The AA-DD model is described with a diagram consisting of two curves (or lines); an AA curve representing AAsset market equilibria derived from the money market and foreign exchange markets and a DD curve representing goods market (or DDemand) equilibria. The intersection of the two curves identifies a market equilibrium in which each of the three markets is in equilibrium simultaneously.Thus, we refer to this equilibrium as a "Super-Equilibrium."

Results

The main results of this section are descriptive and purely mechanical. The chapter describes the derivation of the AA and DD curves, explains how changes in exogenous variables will cause shifts in the curves, and explains adjustment from one equilibrium to another.

a) The DD-curve is the set of exchange rate and GNP combinations that maintain equilibrium in the goods & services market, given fixed values for all other exogenous variables.

b) The DD-curve shifts rightward whenever government demand (G), investment demand (I), transfer payments (TR), or foreign prices (P£), increase or when taxes (T) or domestic prices (P\$) decrease. Changes in the opposite direction cause a leftward shift.

c) The AA-curve is the set of exchange rate and GNP combinations that maintain equilibrium in the asset markets, given fixed values for all other exogenous variables.

d) The AA-curve shifts upward whenever money supply (MS), foreign interest rates (i£), or the expected exchange rate (Ee\$/£), increase, or when domestic prices (P\$) decrease. Changes in the opposite direction cause a downward shift.

e) The intersection of the AA and DD curves depicts a Super Equilibrium in an economy since at that point the Goods and Services market, the domestic money market and the foreign exchange market are all in equilibrium simultaneously.

f) Changes in any exogenous variable that is not plotted on the axes (anything but Y and (E\$/£) will cause a shift of the AA or DD curves and move the economy out of equilibrium, temporarily. Adjustment to a new equilibrium follows the principle that adjustment in the asset markets occurs much more rapidly than adjustment in the goods and services market. Thus, adjustment to the AA-curve will always occur before adjustment to the DD-curve

Connections

The AA-DD model will allow us to understand how changes in macroeconomic policy, both monetary and fiscal, can affect key aggregate economic variables when a country is open to international trade and financial flows, all the while accounting for the interaction of the variables among themselves. Specifically, the model is used to identify potential effects of fiscal and monetary policy on exchange rates, trade balances, GDP levels, interest rates, and price levels both domestically and abroad. In subsequent chapters, analyses will be done under both floating and fixed exchange rate regimes.

International Finance Theory and Policy - Chapter 60-0: Last Updated on 1/23/05