International Finance Theory and Policy
by Steven M. Suranovic
Finance 603

Derivation of the AA CurveThe AAcurve is derived by transferring information described in the money market and foreign exchange market models onto a new diagram to show the relationship between the exchange rate and equilibrium GNP. Since both models describe supply and demand for money, which is an asset, I’ll refer to the two markets together as the asset market. The foreign exchange market, depicted in the top part of the adjoining diagram, plots the rates of return on domestic US assets (RoR_{$}) and foreign British assets (RoR_{£}). (See section 207 for a complete description). The domestic US money market, in the lower quadrant, plots the real US money supply (M^{S}_{$}/P_{$}) and real money demand (L(i_{$}, Y_{$})). The asset market equilibria have several exogenous variables that determine the positions of the curves and the outcome of the model. These exogenous variables are the foreign British interest rate (i_{£}) and the expected future exchange rate (E^{e}_{$/£}), which influence the foreign British rate of return (RoR_{£}), the US money supply (M^{S}_{$}) and domestic US price level (P_{$}), which influence real money supply, and US GNP (Y_{$}), which influences real money demand. The endogenous variables in the asset model are the domestic interest rates (i_{$}) and the exchange rate (E_{$/£}). See the adjoining table for easy reference.
Initially, let’s assume GNP is at a value in the market given by Y_{$}^{1}. We need to remember that all of the other exogenous variables that affect the asset market are also at some initial level such as i_{£}^{1}, E^{e}_{$/£}^{1}_{, }M^{S1}_{$}, and P_{$}^{1}. The real money demand function with GNP level Y_{$}^{1} intersects with real money supply at point G1 in the money market diagram determining the interest rate i_{$}^{1}. The interest rate in turn determines RoR_{$}^{1} which intersects with RoR_{£} at point G_{2} determining the equilibrium exchange rate E_{$/£}^{1}. These two values are transferred to the lowest diagram at point G establishing one point on the AAcurve (Y_{$}^{1}, E_{$/£}^{1}). Next, suppose GNP rises, for some unstated reason, from Y_{$}^{1} to Y_{$}, ceteris paribus. The ceteris paribus assumption means that all exogenous variables in the model remain fixed. Since the increase in GNP raises real money demand, L(i_{$}, Y_{$}), it shifts out to L(i_{$}, Y_{$}^{2}). The equilibrium shifts to point H_{1} raising the equilibrium interest rate to i_{$}^{2}. The RoR_{$} line shifts right with the interest rate, determining a new equilibrium in the FOREX at point H_{2} with equilibrium exchange rate E_{$/£}^{2}. These two values are then transferred to the diagram below at point H establishing a second point on the AAcurve (Y_{$}^{2} E_{$/£}^{2}). The line drawn through points G and H on the lower diagram is called the AAcurve. The AAcurve plots an equilibrium exchange rate for every possible GNP level that may prevail, ceteris paribus. Stated differently, the AAcurve is the combination of exchange rates and GNP levels that maintain equilibrium in the asset market, ceteris paribus. We can think of is as the set of aggregate AAsset equilibria. A note about equilibria If the economy were at a point off of the AAcurve, like at I in the lower diagram, the GNP level is at Y_{$}^{1} and the exchange rate is E_{$/£}^{2}. This corresponds to point I in the upper diagram where RoR_{£}> RoR_{$}. In the FOREX model, when foreign assets have a higher rate of return than domestic assets, investors respond by buying pounds in exchange for dollars in the foreign exchange market. This leads to a depreciation of the dollar and an increase in E_{$/£}. This continues until RoR_{£}= RoR_{$ }at point G. For all points below the AAcurve, RoR_{£}> RoR_{$}, therefore the behavior of investors would cause an upwards adjustment towards the AAcurve from any point like I to a point like G. Similarly, at a point such as J, above the DDcurve, the GNP level is at Y_{2 }and the exchange rate is E_{$/£}^{1}. This corresponds to point J in the upper diagram where RoR_{$} >RoR_{£} and the rate of return on dollar assets is greater than the rate of return abroad. In the FOREX model when US assets have a higher rate of return than foreign assets, investors respond by buying dollars in exchange for pounds in the foreign exchange market. This leads to an appreciation of the dollar and a decrease in E_{$/£}. This continues until RoR_{£}= RoR_{$ }at point H. For all points above the AAcurve, RoR_{$} >RoR_{£}, therefore the behavior of investors would cause a downwards adjustment to the AAcurve from a point like J to a point like H. As with the DDcurve, it is useful to think of the AAcurve as a river flowing through a valley. The hills rise up both above and below. Just as gravity will move a drop of water down the hill to the river valley, so in much the same way, investor behavior will move the exchange rate, up or down to the lowest point lying on the AAcurve International Finance Theory and Policy  Chapter 603: Last Updated on 3/20/05 