The goods and services market model, the foreign exchange market model and the money market model were integrated and combined together in the AA-DD model. The AA-DD model represents the connection among the three market models through a graphical form. Basically, AA-DD model is composed of the AA line and the DD line. The AA line symbolizes the market balance of assets. The AA line is derived from the foreign exchange market model and the money market model. The DD line symbolizes market balance of demand based on the goods and services market model. If the AA line and the DD line intersects then it is valid to imply that all the three market models are in equilibrium. This situation is known as the Super-Equilibrium.
The DD line is determined by the intersection between the aggregate demand and the GNP. An increase in the rate of exchange would automatically yield an increase to the aggregate demand. After finding the point of equilibrium, a change in the rate of exchange would cause a change in the point of equilibrium, requiring a rightward movement of the GNP. The DD line is the line made from the original point of equilibrium to the new point of equilibrium after the change in the rate of exchange. Thus, the DD curve is simply all the possible points of equilibrium between the GNP and the rate of exchange captured in the goods and service market model if all the exogenous variables are fixed. If this is the case, then the DD line would only shift if the exogenous factors are changed.
The goods and services market model showed the DD line as a collection of different grouping of GNP and exchange rate responsible for the equilibrium. The demand curve shifts towards the right when the demand made by the government, transfer payments, investments and foreign prices raises. It could also move towards the right if the price of domestic products and taxes becomes lower.
There are other systems that
The AA line is determined by the intersection between the exchange rate (endogenous) and the GNP (exogenous). The return of exchange for the US dollar is determined by the rates of interest, which is determined by the real money demand and the real money supply. The first point in the AA line is determined by the intersection of the GNP and the rate of exchange in the assets market. The second point of the line is determined by the increase in GNP, which lowers the rates of exchange. The new point of equilibrium is the second point in the AA line. In the asset market, the exogenous factors are the rates of interest in the foreign country, the expected exchange rate, the supply of money in the country, the level of prices in the country and the GNP of the country. The endogenous factors are the interest rates in the country and the actual rate of exchange.
The market of assets determinie the AA line. Unlike the DD line which shifts horizontally, the AA line shifts vertically. It moves upward when there is a decrease in the domestic market. Moreover, it also tend to move upward when there is an increase in the foreign rates of interest, the expected exchange rate and the amount of money supply.
In both lines, if the variables behave differently there would be an opposite movement in the graphical line. Moreover, the given situations above only applies when the exogenous factors are fixed. Otherwise, the lines would not be in equilibrium. If the graphical intersection of the AA-DD is steep, this denote that there are rapid changes in the market of assets. Since the movement in the market of assets changes more quickly than the market of goods and services, then the DD curve would only move after the AA curve. The AA-DD model is important in the determination of fiscal and monetary policies. The model could help analyze the possible impact of the macroeconomic policies to the level of GDP, the rates of interests, the rates of exchange, and in foreign and national price levels.
Aside from the exchange rate, another important factor in devising macroeconomic policies would be the balance of current accounts. Since this was not explicitly shown in the AA-DD model, it is important to understand how its position could be determines. The balance in current account is possible since it determines the balance of payments. An iso-CAB line could be drawn in the AA-DD graph if the balance in the current account are similar. The iso-CAB line could represent the current account balance that depends on the super-equilibrium. If the iso-CAB is higher than the super-equilibrium of the AA-DD line, then the balance on current account is greater. It is important to assess the iso-CAB line because it would give a preview on the possible effect of the macroeconomic policy to the AA-DD markets.
Chapter 70
The AA-DD model could affect the macroeconomic policy in different ways. In an economy where the exchange rate is not fixed, the supply of money is regulated by the nations central bank. The central bank could create expansionary policies that could increase the supply of money or they could create contractionary policies that could lessen the amount of money. The expansionary policy of the central bank could change the AA line upward while the DD line remains the same. This entails an increase in the GNP and an increase in the exchange rate. The change in the increase rates denotes that the countrys currency decreases while the foreign currency increase. Thus, the expansionary policy creates depreciation in the countrys currency. Since the AA line increase upward, the iso-CAB would have a corresponding increase emphasizing the increase in the amount of current account balance. If a contractionary policy is made, the reverse scenario would apply.
Another type of macroeconomic policy is the fiscal policy. This policy is concerned with the profits and expenses made in the government system. The balance in the government budget would therefore affect fiscal policy. The increase in government expenses and the decrease in revenue from taxes is known as an expansionary fiscal policy. If the opposite scenario holds true, then the fiscal policy is contractionary.
An expansionary fiscal policy affects the demand for goods and services and the demand for consumption. This creates an increase in the aggregate demand. If there is an expansionary fiscal policy, the DD line will move to the right. Such movement would also cause the AA-DD super-equilibrium to shift rightward. The rate of exchange would fall while the GNP increase. Since the rate of exchange decreased, then a corresponding foreign currency would decrease against the increase in the countrys currency. This implies an appreciation of the countrys currency. The new super-equilibrium would be below the former iso-CAB line denoting a decrease in the amount of current account balance. If a contrationary fiscal policy occurs, the reverse scenario would apply.
All the above discussions happen in the short-run. In a long-run scenario, an expansionary monetary policy would shift the AA line upward. The change would occur quickly because exchange rate changes in faster than GNP. The scenario would prompt the investors to expect an inflation, which increases the expected rate of exchange. This would create another upward shift to the AA line. The long-term effect would include a further depreciation in the value of the countrys currency. The DD line would shift to the left because there would be an increase in prices. The real rate of exchange would decrease. In this scenario, the prices of foreign products become cheaper than domestic products. This would push the AA line downward because the supply of money would fall as the prices of products increase. The decrease in the supply of money would result to an increase in the rates of interest, which also increases the rates of return for investment on the country. The demand for the countrys currency by foreign investors increases or appreciates. The AA line would move downward along with the decrease in GNP. Finally, the long-run effect of expansion in the supply of money would not create changes in the GNP while the countrys currency depreciated.
The central bank would only intervene to create a steady exchange range or to control the trade deficit in the country. The central bank could indirectly intervene in the rate of exchange by controlling the supply of money in the country. Increasing the supply of money would result to depreciation in the countrys currency. However, this intervention would take too long thus, direct interventions could be made by penetrating the FOREX market. The central bank could purchase or sell the domestic currency in exchange with foreign currency. However, this direct intervention requires a sufficient foreign currency reserve or foreign exchange reserves, which could be accumulated in a long period of time for this particular function. Indirectly, the direct intervention made by the central bank would result to an increase (decrease) in the money supply if they buy (sell) domestic currency from the FOREX market. This creates a reduction in the rates of interests and a further reduction in the rates of return. This leads to a depreciation of the countrys currency. The central bank may not want this to happen, thus, there are times when the central bank chooses to make a sterilized intervention. The sterilization occurs when the central bank tries to counteract the possible domestic effect of the direct intervention in FOREX market. This would mean that open market operations would be use to assure that the rate of exchange and the GNP in the AA-DD model would not be affected by the intervention. This would hold true unless foreign investors would change their expectation about the rate of exchange.
Chapter 80
The rate of exchange of currencies depends on the system that applies between two countries with different currencies. In the current economic milieu, the system of floating rate of exchange dominates to the point of regularity. Nonetheless, a second system known as the fixed rate of exchange exists. In the fixed system, the government is the one responsible for the setting the worth of the countrys currency. Traditionally, gold was used as the standard in assessing the worth of currencies. While floating system based the value of currency with supply and demand, the fixed system relates the value of currency to a fix amount of gold or currency reserve.
Using gold as the standard to fix the value of currency would require a fix amount of currency exchangeable for a specific amount of gold. Such value must be publicly tradable. The countrys central bank must hold a large amount of gold reserves to trade with the public. Using this standard would mean that the exchange rate between two countrys is the ratio between the price of gold in the home country over the price of gold in the foreign country. With this in mind, any increase in the quantity of gold in any country would yield an increase in the supply of money domestically. In a situation where in the GDP do not change and both PPP and IRP are at work, then any increase in the domestic supply of money would not raise the amount of produce. This implies that there will be inflation or an increase in the price of domestic output. When foreign products are cheaper than domestic products, the consumers would practically buy products from overseas. In relation to this, the supply of money in the home country would gradually decrease while the supply of money in other country increases. The scenario would continue until the balance of prices via PPP and rates of return via IRP are achieved. The currency reserved standard works in the same way as the gold standard however, this standard use another countrys currency as a standard to which they fix the value of their currency. By doing this, the central bank must hold a currency reserve of the foreign countrys currency. A mixture of the two standards could also be used as intended by the system of gold-exchange standard. In this system, the foreign country chosen as a reserve needs to determine the price of gold using the reserve countrys currency. In this scenario, central banks are the only ones allowed to exchange money with gold directly.
After World War II, the system for exchange rate was changed to the Bretton-Woods system, which had instituted the International Monetary Fund. The purpose of this institution is to assure that the Bretton-Woods system is standardized and secured. Other than the above-mentioned systems of fixed exchange rate, there are still other systems that are being used in some countries. Saudi Arabia and Botswana both utilize the systems of basket-of-currencies in which the value of their currencies is fixed upon the comparative weight of a group of currencies. The IMF created the SDR or special drawing rights involving specific amounts of Japanese Yen, Euro, US dollars and British pounds, for this particular purpose. In case when the fixed rate would still be changed in certain periods, a system if crawling pegs exists. Instead of creating transitory changes in the fixed rate, the central bank could gradually regulate or alter the fixed rate. If there is an allowable band that allows the fluctuation of currency, then the system being used is pegged within a band. The fixed rate of exchange could also be achieved by creating a currency board that lawfully ensure that the rate would not change and no FOREX intervention could be made to control the rate. The last system that can be use is the adaptation of the foreign currency such that of the Euroization and Dollarization in some countries. This is noted as the extreme means to maintain a fixed exchange rate.
In the floating exchange rate, the central bank does not interfere with the establishment of the currency values and FOREX transactions. In a fixed exchange rate the central bank almost always get involved with FOREX transactions. The interest rate parity could only be attained in the fixed exchange rate system if the interest rates of both nations are the same. The central bank supplies the excess demand or buys the excess supply of currency in the FOREX market to make certain that the fixed rate of exchange is reliable. A balance of payment deficit (surplus) happens when the central bank purchases (sells) home country currency by selling (purchasing) foreign country currency reserves. If the central bank would not meddle with the excess andor deficit in the amount of currency in the FOREX market. The currencies would be exchanged under the established fixed exchange rate. If there will be currency exchanges that involves illegal exchange rate due to not being satisfied with the official rate of exchange, then a Black market in buy and sell of currencies arise.