This is “Overview of the AA-DD Model”, section 20.1 from the book Policy and Theory of International Economics (v. 1.0).
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This chapter describes the derivation and the mechanics of the AA-DD modelRepresents a synthesis of the foreign exchange market, the money market, and the goods and services market, showing their interconnectedness.. The AA-DD model represents a synthesis of the three previous market models: the foreign exchange (Forex) 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 curveThe set of exchange rate and GNP combinations that maintain equilibrium in the asset markets, which is given fixed values for all other exogenous variables. representing asset market equilibriums derived from the money market and foreign exchange markets and a DD curveThe set of exchange rate and GNP combinations that maintain equilibrium in the goods and services market, which are given fixed values for all other exogenous variables. representing goods market (or demand) equilibriums. The intersection of the two curves identifies a market equilibrium in which each of the three markets is simultaneously in equilibrium. Thus we refer to this equilibrium as a superequilibriumDescribes the GNP level and exchange rate value at the intersection of the AA and DD curves. It represents the values that provide for equilibriums in the money market, the Forex market, and the G&S market simultaneously..
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.
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 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.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”