This is “Shifting the DD Curve”, section 9.3 from the book Policy and Theory of International Finance (v. 1.0).
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The DD curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the goods and services (G&S) market model. The exogenous variable assumed to change is the exchange rate. The endogenous variable affected is the gross national product (GNP). At all points along the DD curve, it is assumed that all other exogenous variables remain fixed at their original values.
The DD curve will shift, however, if there is a change in any of the other exogenous variables. We illustrate how this works in Figure 9.3 "DD Curve Effects from a Decrease in Investment Demand". Here, we assume that the level of investment demand in the economy falls from its initial level I_{1} to a lower level I_{2}.
At the initial investment level (I_{1}) and initial exchange rate (E_{$/£}^{1}) the AD curve is given by AD(…, E_{$/£}^{1}, I_{1}, …). The AD curve intersects the forty-five-degree line at point G, which is transferred to point G on the DD curve below. If the investment level and all other exogenous variables remain fixed while the exchange rate increases to E_{$/£}^{2}, then the AD curve shifts up to AD(…, E_{$/£}^{2}, I_{1}, …), generating the equilibrium points H in both diagrams. This exercise plots out the initial DD curve labeled DD|_{I}_{1} in the lower diagram connecting points G and H. DD|_{I}_{1} is read as “the DD curve given that I = I_{1}.”
Figure 9.3 DD Curve Effects from a Decrease in Investment Demand
Now, suppose I falls to I_{2}. The reduction in I leads to a reduction in AD, ceteris paribus. At the exchange rate E_{$/£}^{1}, the AD curve will shift down to AD(…, E_{$/£}^{1}, I_{2}, …), intersecting the forty-five-degree line at point K. Point K above, which corresponds to the combination (E_{$/£}^{1}, I_{2}), is transferred to point K on the lower diagram. This point lies on a new DD curve because a second exogenous variable, namely I, has changed. If we maintain the investment level at I_{2} and change the exchange rate up to E_{$/£}^{2}, the equilibrium will shift to point L (shown only on the lower diagram), plotting out a whole new DD curve. This DD curve is labeled D′D′|_{I}_{2}, which means “the DD curve given is I = I_{2}.”
The effect of a decrease in investment demand is to lower aggregate demand and shift the DD curve to the left. Indeed, a change in any exogenous variable that reduces aggregate demand, except the exchange rate, will cause the DD curve to shift to the left. Likewise, any change in an exogenous variable that causes an increase in aggregate demand will cause the DD curve to shift right. An exchange rate change will not shift DD because its effect is accounted for by the DD curve itself. Note that curves or lines can shift only when a variable that is not plotted on the axis changes.
The following table presents a list of all variables that can shift the DD curve right and left. The up arrow indicates an increase in the variable, and the down arrow indicates a decrease.
DD right-shifters | ↑G ↑I ↓T ↑TR ↓P_{$} ↑P_{£} |
DD left-shifters | ↓G ↓I ↑T ↓TR ↑P_{$} ↓P_{£} |
Refer to Chapter 8 "National Output Determination" for a complete description of how and why each variable affects aggregate demand. For easy reference, recall that G is government demand, I is investment demand, T refers to tax revenues, TR is government transfer payments, P_{$} is the U.S. price level, and P_{£} is the foreign British price level.
Identify whether the DD curve shifts in response to each of the following changes. Indicate whether the curve shifts up, down, left, or right. Possible answers are DD right, DD left, or neither.