AA DD Model

1

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Equilibrium starting point
E1
AA1 (M,E,R, P)
Y Y
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left)
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right) AA Curve MMoney
Supply EExpected Future Exch.Rate RIntl
Rate All Positive Relationship to DD Curve
P Prices (Domestic)
-- Negative Relationship to DD Curve
2

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Step 1 (Immediate impact) If there is
a monetary contraction (M )
E1
AA1 (M,E,R, P)
Y Y
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left)
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right) AA Curve MMoney
Supply EExpected Future Exch.Rate RIntl
Rate All Positive Relationship to DD Curve
P Prices (Domestic)
-- Negative Relationship to DD Curve
3

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Step 1 (Immediate impact) If there is
a monetary contraction (M ) Then AA1 shifts
left to AA2 The result is GDP drops to Y2 and the
currency appreciates to E2. Because this shift
does not account for price stickiness
adjustments, we have an undershooting. where
the currency has a greater appreciation rate in
the short-term than what its long-term exchange
rate will be after price adjustments
Step 1
E1
E2
AA1 (M,E,R, P)
AA2(M )
Y
Y
Y2
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left (or down))
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right (or up)) AA Curve
MMoney Supply EExpected Future Exch.Rate
RIntl Rate All Positive Relationship to DD
Curve P Prices
(Domestic) -- Negative Relationship to DD Curve

4

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Aggregate Demand /Supply Curve
P
Agg.Supply
Prices adjust downwards
Analysis Step 2 (Transitional Effect-Sticky
prices) Though money supply (M) decreases,
prices (P) do not immediately adjust downwards
since they are sticky. As a result, since prices
are relatively high, people consume less and
firms accumulate excess inventory. To get rid
of excess inventory, firms lower prices, which
stimulates demand. This increased demand
stimulates production which leads to greater
employment and a stronger economy.
P P2
Agg. Demand
Y2 Y Y
Economy moves towards Full employment as
prices decrease
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left)
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right) AA Curve MMoney
Supply EExpected Future Exch.Rate RIntl
Rate All Positive Relationship to DD Curve
P Prices (Domestic)
-- Negative Relationship to DD Curve
5

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Step 3 (Long-run) This is where we
were prior to price adjustment and with an
exchange rate undershooting Now watch what
happens to the AA and DD curves when prices adjust
E1 E2
AA2(M)
Y2 Y Y
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left (or down))
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right (or up)) AA Curve
MMoney Supply EExpected Future Exch.Rate
RIntl Rate All Positive Relationship to DD
Curve P Prices
(Domestic) -- Negative Relationship to DD Curve

6

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

AA / DD Model
E
DD1 (T,P, G,I, P)
DD2 (P )
Analysis Step 3 (Long-run) As we saw in the
aggregate demand curve, prices (P) adjust
downwards. Price (P) affects both the AA and DD
curve. The relationship is negative meaning
that as prices go down, both the AA and DD
curve shift to the right (or up if you
prefer) until they hit full employment at Y and
the Long-run exchange rate settles at E3.
E1 E2
E3
AA3(P )
AA2
Y2
Y
Y
Key DD Curve TTaxes PPrices (Domestic)
Note These variables have a negative
relationship to AA curve (I.e. if Taxes increase,
DD curve shifts left (or down))
GGov Spending IInvestment
PPrices(Foreign) Note Positive relationship
to AA Curve (I.e. if Investment increases, DD
curve goes right (or up)) AA Curve
MMoney Supply EExpected Future Exch.Rate
RIntl Rate All Positive Relationship to DD
Curve P Prices
(Domestic) -- Negative Relationship to DD Curve

7

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Equilibrium starting point
E1
E Ee 1R-R
R (Domestic)
R1
L(R,Y)
M1 P1
New Key for MM/EE graph
Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
8

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 1 There is a permanent monetary
Contraction (M ) than money demand decreases
M P
E1
E Ee 1R-R
R (Domestic)
R1
L(R,Y)
M1 P1
Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate Purchasing
Power Parity Equation PEP where PPrices
(Domestic) PPrices(Foreign) EExchange rate
9

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 1 If there is a permanent
monetary Contraction (M ) than money demand
decreases M P As a result, M1
shifts back to M2 P1
P2 And the domestic rate
increases to R2 Now lets take a look at the
exchange rate portion of this graph. Do not try
to connect the Line from M2 to the exchange
rate curve yet. P2
E1
E Ee 1R-R
R (Domestic)
R1
R2
L(R,Y)
M2 P2

M1 P1
Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate Purchasing
Power Parity Equation PEP where PPrices
(Domestic) PPrices(Foreign) EExchange rate
10

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 2 (Shift in exch curve due to
chg in expectations) Remember, anytime the policy
change is permanent, we will see a change in
expectations for future exchange rates in a
floating rate regime. With a money supply
contraction, what change should we expect in the
exch.rate curve? A clue comes from the
Purchasing Power Parity Equation P E P where
we assume foreign prices stay fixed
E1
E Ee 1R-R
R (Domestic)
R1 R2
L(R,Y)
M2 P2

Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate
11

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 2 (continued) Based on the
Aggregate Demand/Supply curve we saw earlier, we
know that domestic prices will adjust Downwards
in the future. If future prices are expected to
drop, (lets call this Pe) than the future
exchange rate (Ee) will also drop assuming that
foreign prices will remain unchanged. Pe
Ee P
E1
E Ee 1R-R
R (Domestic)
R1 R2
L(R,Y)
M2 P2

Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate
12

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 2 (continued) If the future
expected exchange rate is to appreciate, then the
current exchange rate will adjust immediately.
Ee E ( current exch rate
curve) !R-R As a result, the
exchange rate curve will shift Downwards. The
new current exchange rate curve is E2
E1
E Ee 1R-R
E2
R (Domestic)
R1 R2
L(R,Y)
M2 P2

Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate
13

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 2 (continued) After the new
exchange rate curve has been found, the new
exchange rate (E2) can be found by connecting
the line from the money demand curve to the new
current exchange rate curve. . Keep in mind, E2
is the exchange rate before sticky prices have
adjusted, hence we have our undershooting
phenomenon just like in our AA/DD model
E1
E Ee 1R-R
E2
E2
R (Domestic)
R1 R2
L(R,Y)
M2 P2

Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate
14

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 3 Sticky Price Adjustment
As prices adjust downwards,
money demand increases
E1
E Ee 1R-R
M P
E2
E2
R (Domestic)
R3 R2
For this exercise, let us assume that
money demand increases back to its original
starting point which will now be called M3
P3
L(R,Y)
M2 P2

M3 P3
Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate
15

• Question 1 Floating Exchange Rates-Sticky
  Prices- Monetary Policy (10 points)
• Given
• Monetary contraction
• Sticky prices (Prices adjust)
• Floating exchange rate
• Permanent change
• Assume Already at full employment (Y)

Money Market / Exchange Rate Equil. Perspective
Analysis Step 3 Sticky Price Adjustment The
new money demand line can now be traced to the
new current exchange rate curve in order to find
the long-term exchange rate (E3) The immediate
undershooting exchange rate movement, transitionin
g price adjustments and long-term exchange
rate position corresponds with what we saw on the
AA/DD model
E1
E3
E Ee 1R-R
E2
E2
R (Domestic)
R3 R2
L(R,Y)

M3 P3
Key Money Market side MMoney Supply
PPrices(Domestic) M/P Money Demand L(R,Y)
Economy as a function of RRate(Domestic) and
YOutput) Exchange Rate side RRate
(International) EeExpected future exchange
rate ECurren exchange rate
Purchasing Power Parity Equation PEP where
PPrices (Domestic) PPrices(Foreign)
EExchange rate