International Finance Theory and Policy
by Steven M. Suranovic

Finance 60-2

Shifting the DD-Curve

T he DD-curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the G&S market model. The exogenous variable assumed to change is the exchange rate. The endogenous variable affected is GNP. At all points along the DD-curve it is assumed that all other exogenous variables remain fixed at their original values.   

The DD-curve will shift, however, if there is a change in any of the other exogenous variables.We illustrate how this works in the adjoining diagram. Here we assume that the level of investment demand in the economy falls from its initial level I1 to a lower level I2.

At the initial investment level, I1, and initial exchange rate, E$/£1, the AD curve is given by AD( …, E$/£1, I1, .. ).The AD curve intersects the 45Ί-line at point G, which is transferred to point G on the DD curve below.If the investment level, and all other exogenous variables remain fixed while the exchange rate increases to E$/£2 then the AD curve shifts up to AD( …, E$/£2, I1, … ) generating the equilibrium points H in both diagrams.This exercise plots out the initial DD curve labeled DD|I1 in the lower diagram connecting points G and H. DD|I1 is read as “the DD curve given that I = I1”.

Now, suppose I falls to I2. The reduction in I leads to a reduction in AD, ceteris paribus. At the exchange rate E$/£1, the AD curve will shift down to AD( …, E$/£1, I2, … ) intersecting the 45Ί-line at point K. Point K above, which corresponds to the combination (E$/£1, I2), is transferred to point K on the lower diagram. This point lies on a new DD-curve because a second exogenous variable, namely I, has changed. If we maintain the investment level at I2 and change the exchange rate up to E$/£2 the equilibrium will shift to point L (shown only on the lower diagram), plotting out a whole new DD-curve. This DD-curve is labeled D’D’|I2 which means “the DD curve given that I = I2”.

The effect of a decrease in investment demand is to lower aggregate demand and shift the DD-curve to the left.Indeed, a change in any exogenous variable that reduces aggregate demand, with the exception of the exchange rate, will cause the DD curve to shift to the left. Likewise, any change in an exogenous variable that causes an increase in aggregate demand will cause the DD-curve to shift right. An exchange rate change WILL NOT shift DD because its effect is accounted for by the DD-curve itself. [NB: Curves/lines can shift only when a variable NOT plotted on the axis changes]

The following table presents a list of all variables that can shift the DD-curve right and left. The up-arrow indicates an increase in the variable, a down-arrow a decrease.

DD right-shifters

↑G ↑I ↓T ↑TR ↓P$ ↑P£

DD left-shifters

↓G ↓I ↑T ↓TR ↑P$ ↓P£

Refer back to Chapter 50 for a complete description of how and why each variable affects aggregate demand. For easy reference though, recall that G is government demand, I is investment demand, T refers to tax revenues, TR is government transfer payments, P$ is the US price level and P£ is the foreign British price level.

International Finance Theory and Policy - Chapter 60-2: Last Updated on 1/23/05