International Finance Theory and Policy
by Steven M. Suranovic

Finance 60-4

Shifting the AA-curve

The AA-curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the asset market model. The exogenous variable changed is GNP. The endogenous variable affected is the exchange rate. At all points along the AA-curve it is assumed that all other exogenous variables remain fixed at their original values.

The AA-curve will shift 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 money supply in the economy falls from its initial level MS1 to a lower level MS2.

At the initial money supply, MS1, and initial GNP levelY\$1, real money demand intersects real money supply at point G, determining the interest rate i\$1. This in turn determines the rate of return on US assets, RoR\$1, which intersects the foreign British RoR£ at G in the upper diagram determining the equilibrium exchange rate E\$/£1. If the money supply, and all other exogenous variables remain fixed while GNP increases to Y\$2 the equilibria shift to points H in the lower and upper diagrams determining exchange rate E\$/£2. This exercise plots out the initial AA-curve labeled AA|MS1 in the lower diagram connecting points G and H. Note, AA|MS1 is read as “the AA-curve given that MS = MS1."

Now, suppose the money supply MS falls to MS2. The reduction in MS leads to a reduction in the real money supply which, at GNP level Y\$1, shifts the money market equilibrium to point I determining a new interest rate i\$3. In the FOREX market the rate of return rises to RoR\$3 which determines the equilibrium exchange rate E\$/£3.      The equilibria at points I correspond to the combination (Y\$1, E\$/£3), is transferred to point I on the lower diagram. This point lies on a new AA-curve because a second exogenous variable, namely MS, has changed. If we maintain the money supply at MS2 and change the GNP up to Y\$2 the equilibrium will shift to point J (shown only on the lower diagram), plotting out a whole new AA-curve. This AA-curve is labeled A’A’|MS2 which means “the AA-curve given that MS = MS2”.

The effect of a decrease in the money supply is to shift the AA-curve downward. Indeed, a change in any exogenous variable in the asset markets that reduces the equilibrium exchange rate, with the exception of a change in GNP, will cause the AA-curve to shift down. Likewise, any change in an exogenous variable that causes an increase in the exchange rate will cause the AA-curve to shift up. A change in GNP will NOT shift AA because its effect is accounted for by the AA-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 AA-curve upand down. The up-arrow indicates an increase in the variable, a down-arrow a decrease.

 AA up-shifters ↑MS↓P\$ ↑i£ ↑Ee\$/£ AA down-shifters ↓MS ↑P\$ ↓i£ ↓Ee\$/£

Refer back to Chapter 20 and Chapter 40 for a complete description of how and why each variable affects the exchange rate. For easy reference though, recall that MS is the US money supply, P\$ is the US price level, i£ is the foreign British interest rate, and Ee\$/£ is the expected future exchange rate.

International Finance Theory and Policy - Chapter 60-4: Last Updated on 1/23/05