International Finance Theory and Policy
by Steven M. Suranovic

Finance 60-5

# Super-Equilibrium: Combining DD and AA

The DD-curve represents the set of equilibria in the G&S market. It describes an equilibrium GNP level for each and every exchange rate that may prevail. Due to the assumption that firms respond to excess demand by increasing supply and to excess supply by decreasing supply, GNP rises or falls until the economy is in equilibrium on the DD-curve.

The AA-curve represents the set of equilibria in the asset market. It indicates an equilibrium exchange rate for each and every GNP level that might prevail. Due to the assumption that investors will demand foreign currency when the foreign rate of return exceeds the domestic return, and that they will supply foreign currency when the domestic rate of return exceeds the foreign return, the exchange rate will rise or fall until the economy is in equilibrium on the AA-curve.

Since both the G&S market and the asset markets are operating concurrently, equilibria in both markets can only occur where the DD curve intersects the AA curve. This is shown in the adjoining diagram at F, with equilibrium GNP, Ŷ\$, and exchange rate, Ê\$/£. It is worth emphasizing that at point F, three markets, the G&S market, the money market and the foreign exchange market are in equilibrium simultaneously. For this reason point F is more than a plain old equilibrium, instead it is a Super-Equilibrium.

The super-equilibrium point is where we would expect behavioral responses by firms households and investors, to move the exchange rate and GNP level, assuming the exogenous variables remain fixed at their original levels and assuming sufficient time is allowed for adjustment to the equilibrium to take place.

The equilibrium at F is like the lowest point of two intersecting valleys that reach their combined lowest point at a pool where the two valleys meet. A 3-D rendition of this is shown. The steepness of the valleys is meant to represent the speed of adjustment. Thus the AA-valley is drawn much steeper than the DD-valley to reflect the much more rapid adjustment in the asset markets in comparison to goods market adjustment. Anytime the economy is away from the equilibrium, forces will act to move it to the pool in the center. However, as will be shown later, adjustment to the AA-curve will occur much faster than adjustment to the DD-curve.

International Finance Theory and Policy - Chapter 60-5: Last Updated on 3/20/05