Aa-Dd Model

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Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

Slides for International Finance
Aggregate Demand and the SR (KOM Chapter 17)

Alan G. Isaac
American University

2012-10-22

Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

PREVIEW
AA Curve
review SR model of asset market equilibrium
AA: Y
E (to maintain asset mkt eq)
DD Curve
SR model of output market equilibrium
DD: E
Y (to maintain asset mkt eq)
SR Model
AA + DD: simultaneous output market and asset market
equilibrium
temporary v permanent changes in monetary and fiscal policies liquidity trap (zero interest rates, deflation, stimulus)
Adjustment of the current account over time.
IS-LM model
alternative perspective on the same results

^ _

^ ^

Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

SR vs. LR Models
LR models
all prices of inputs and outputs have time to adjust.
predict future exchange rate tendencies
suggest ways of thinking about how market participants form
expectations
SR models
some prices of inputs and outputs do not fully adjust
labor contracts
costs of adjustment
imperfect information about market demand.

Goal
show how macroeconomic policies affect E, Y, and CA
Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

Short-Run Equilibrium in Asset Markets

Consider two related asset markets:
money market: M/P = L(R, Y)
Y
L
(M/P < L)
R

^ ^ 
^
foreign exchange market: R = R* + (Ee - E)/E
^R  _E
When income (production) increases:
the demand for real liquidity increases,
driving up the domestic interest rate,
causing an appreciation of the domestic currency.

^  _E

Summary: Y

Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

Output and the Exchange Rate in Asset Market Equilibrium
E

E1

E2

R1

R2

R

M /P

L( R , Y 1 )

L( R , Y 2 )

Q
Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

Short-Run Equilibrium in Asset Markets: AA Curve

AA Curve
equilibrium in financial markets (money market and foreign
exchange market)
inverse relationship between output and exchange rates (as
dervied above)

Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

The AA Schedule
E

E1

E2

AA
Y1
Alan G. Isaac

Y2
Slides for International Finance

Y

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

Shifting the AA Curve

1

2
3

4

5

^M  _R (in the short run)  ^E (for every Y): the AA curve
shifts up
^P  _M/P  ^R  _E (given Y): the AA curve shifts down
^L (exogenously)  ^R  _E (given Y): the AA curve shifts
down
^R*  foreign currency deposits more attractive  ^E (given Y): the AA curve shifts up
^ Ee: if market participants expect the future domestic currency to be depreciated, foreign currency deposits become more
attractive,  ^E (given Y): the AA curve shifts up
Alan G. Isaac

Slides for International Finance

Introductory Concepts
Short-Run Model: DD and AA
Liquidity Trap
Macro Policy and CA

AA Curve
Aggregate Demand

^M  ^E in Assets Markets
E

E2

E1

R2

R1

R
M1 /P
M2 /P

L(R , Y1 )
Q
Alan G. Isaac

Slides for International Finance

Introductory Concepts...
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