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20.1 Overview of the AA-DD Model

Learning Objective

  1. Understand the basic structure and results of the AA-DD model of national output and exchange rate determination.

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..

Results

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.

  1. The DD curve is the set of exchange rate and GNP combinations that maintain equilibrium in the goods and services market, given fixed values for all other exogenous variables.
  2. The DD curve shifts rightward whenever government demand (G), investment demand (I), transfer payments (TR), or foreign prices (P£) increase or when taxes (T) or domestic prices (P$) decrease. Changes in the opposite direction cause a leftward shift.
  3. The AA curve is the set of exchange rate and GNP combinations that maintain equilibrium in the asset markets, given fixed values for all other exogenous variables.
  4. The AA curve shifts upward whenever money supply (MS), foreign interest rates (i£), or the expected exchange rate (E$/£e) increase or when domestic prices (P$) decrease. Changes in the opposite direction cause a downward shift.
  5. The intersection of the AA and DD curves depicts a superequilibrium in an economy since at that point the goods and services market, the domestic money market, and the foreign exchange market are all in equilibrium simultaneously.
  6. Changes in any exogenous variable that is not plotted on the axes (anything but Y and E$/£) will cause a shift of the AA or DD curves and move the economy out of equilibrium, temporarily. Adjustment to a new equilibrium follows the principle that adjustment in the asset markets occurs much more rapidly than adjustment in the goods and services market. Thus adjustment to the AA curve will always occur before adjustment to the DD curve.

Connections

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.

Key Takeaways

  • The AA-DD model integrates the workings of the money-Forex market and the G&S model into one supermodel.
  • The AA curve is derived from the money-Forex model. The DD curve is derived from the G&S model.
  • The intersection of the AA and DD curves determines the equilibrium values for real GNP and the exchange rate.
  • Comparative statics exercises using the AA-DD model allow one to identify the effects of changes in exogenous variables on the level of GDP and the exchange rate, while assuring that the Forex, the money market, and the G&S market all achieve simultaneous equilibrium.

Exercise

  1. 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?”

    1. At the intersection of the AA and DD curves, the goods and services market, the money market, and this market are simultaneously in equilibrium.
    2. The term used to describe the type of equilibrium at the intersection of the AA curve and the DD curve.