AA DD Model

1

• Question 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Starting point
E1
AA1 (M,E,R, P)
Y1 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 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Short-term impact on AA/DD model Step
1 If R increases then the AA1 curve shifts out
to AA2 This stimulates the economy to Y
and leads to a depreciation of the currency to
E2 Since the exchange rate is supposed to be
fixed, the central bank intervenes to appreciate
the currency by selling official international
reserves (OIR) with local currency which is like
decreasing the money supply.
E2
E1
AA2 (R )
AA1 (M,E,R, P)
Assets Liabilities
OIR High-powered money (H)
(also equivalent to an
decrease Domestic credit in money supply
(M)) (I.e. treasury bonds)
Y1 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 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

AA / DD Model
E
DD1 (T,P, G,I, P)
Analysis Short-term impact on AA/DD model Step
2 Since money supply (M) has decreased, The AA2
curve shifts back to AA1 and the economy moves
back to Y1 (or some point under full
employment.) E2 will move back to E1

E2
E1
AA2
In a fixed rate regime under the AA/DD model, the
positive economic impact due to an increase in
international rates will be negated by the
negative impact from a decrease in money supply
due to CB intervention which is immediate.
Short-termlong-term
AA1 (M )
Y1 Y Y
Special note DD model with regards to changes
in Domestic Rates Although changes in
domestic rates ( R ) should affect Investment
(I), in the AA/DD model, investment is considered
exogenous and therefore the DD curve
will not shift.
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
4

• Question 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

ISLM-BP Model
R
LM1 (M, P)
Analysis Equilibrium starting point
RRd
BP
IS1 (C,I,G,CA)
Y1 Y Y
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl) d (Risk
Premium)
5

• Question 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

ISLM-BP Model
R
LM1 (M, P)
Analysis Short-term impact on ISLM model Step 1
If nom. Intl. Rates go up then Rlt R This
leads to capital outflows which will cause a
depreciation of the local currency. Why? Ee
E (Interest Rate Parity
Condition) 1R- R The central bank will
intervene by selling OIR to appreciate the
currency
R
RRd
BP
IS1 (C,I,G,CA)
Assets Liabilities
OIR High-powered money (H)
(also equivalent to a
decrease Domestic credit in money supply
(M)) (I.e. treasury bonds)
Y1 Y Y
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl)

d (Risk Premium)
6

• Question 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 1 Recession and Unemployment
• (Below full employment (Y))

ISLM-BP Model
R
LM2 (M )
LM1 (M, P)
Analysis Short-term impact on ISLM model Step 2
Since money supply (M) has decreased, The LM1
curve shifts back to LM2 and the economy moves
back to Y2. Because the M has decreased domestic
rates have increased to equal the new
intl nominal rate hence you see the new BP line.
BP2
RRd
BP1
RRd
IS1 (C,I,G,CA)
In a fixed rate regime under the ISLM-BP model,
a rise in R causes a depreciation which the CB
will offset by appreciating the currency
(reducing M). This will raise domestic rates and
hurt an economy even more.
Y2 Y1 Y
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl)

d (Risk Premium)
7

• Question 3A Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• SCENARIO 2 In an overheated economy where the
  economy is past Y, the model mechanics are still
  the same

AA / DD Model ISLM-BP Model
E
R
LM2 (M )
DD1 (T,P, G,I, P)
LM1 (M, P)
BP2
E2
RRd
RRd
E1
1 2
BP1
2 1
AA2
AA1 (M )
IS1 (C,I,G,CA)
Y Y1 Y2 Y
Y Y1
1 2
8

• Question 3B Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• STERILIZING OUTFLOW OF CAPITAL

Money Market / Exchange Rate Equil. Perspective
Analysis Equilibrium starting point
E1
E Ee 1R-Rd
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 d Risk Premium
9

• Question 3B Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• STERILIZING OUTFLOW OF CAPITAL

Money Market / Exchange Rate Equil. Perspective
E2
Analysis A rise in R would lead to capital
outflows causing A depreciation on the local
currency to E2
E1
E2 Ee 1R-R d
E Ee 1R-Rd
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
10

• Question 3B Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• STERILIZING OUTFLOW OF CAPITAL

Money Market / Exchange Rate Equil. Perspective
E2
Analysis The central bank would immediately
intervene by selling OIR (or buying local
currency and taking it out of circulation) thereby
appreciating the local currency but reducing
the money supply which shifts the money demand
curve back to M2 . E2 now appreciates back to
E1 P2
E1
E2 Ee 1R-R d
E Ee 1R-Rd
R (Domestic)
R1
R2
L(R,Y)
Assets Liabilities
OIR High-powered money (H)
(also equivalent to an
decrease Domestic credit in money supply
(M)) (I.e. treasury bonds)
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
11

• Question 3B Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• STERILIZING OUTFLOW OF CAPITAL

Money Market / Exchange Rate Equil. Perspective
E2
Analysis By correcting the exchange rate
issue, the resulting reduction in money supply
will slow the economy by raising domestic
interest rates to R2. Sterilization would
correct this problem. To attract foreign
capital the govt could offer treasury bonds
with a higher risk premium, thereby lowering the
exchange rate curve. This increase in domestic
credit would increase high-powered money and
thereby reduce domestic rates back down to R1,
minimizing any economic Impacts from a rise in
R
E1
E2 Ee 1R-Rd
E Ee 1R-Rd
R (Domestic)
R2
R1
L(R,Y)
M2 P2
Assets Liabilities
OIR High-powered money (H)
(also equivalent to an
decrease Domestic credit in money supply
(M)) ( treasury bonds)
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
12

• Question 3C Fixed Exchange Rates-Sticky Prices-
  Increase in Nominal International Rate (20
  points)
• Given
• Increase in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change
• POLICY RECOMMENDATION Sterilize if scenario 1.
  Do not sterilize if scenario 2

Scenario 2 (Overemployment) Do NOT sterilize.
The rise in R will lead to capital outflows
causing a depreciation. The CB would
intervene would selling OIR thereby
appreciating the currency. The resulting
decrease in high-powered money (H) would cool off
the overheated economy. Sterilization would
simply keep the economy overheated
Scenario 1 (Underemploymentt) DO sterilize. The
rise in R will lead to capital outflows
causing a depreciation. The CB would
intervene would selling OIR thereby
appreciating the currency. The resulting
decrease in high-powered money (H) would
slowl the economy more making it worse
off. Sterilization would help offset the negative
effects of a CB currency appreciation
intervention One risk of sterilization is that
the country default risk grows from the issuance
of bonds if the bonds are used primarily to
finance a consumption-based fiscal deficit. In
order to entice investment, the govt will raise
the risk premium which further exacerbates
country default risk because investors will
question the governments ability to pay back
both the interest and principal of the bonds. A
second risk is that the govt may run out of
bonds and be forced to borrow from the central
bank. This leads to what is called a
quasi-fiscal deficit.