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Lecture notes: 160B

revised 4/24/01
Lecture 5A: Introduce DD and AA Curves
(first half of chapter 16)
Topics: Aggregate Demand
Equilibrium in the goods market: DD curve
Asset market: AA curve
Overall Equilibrium
1) Aggregate Demand
a) Def: amount of countrys goods and services that people at home and abroad
together are willing and able to purchase.
Represent with D.
Are several components to aggregate demand: D = C + I + G + CA
(demand is sum of consumption, investment , government
expenditure and foreign demand)
b) Consumption: What determines consumption:
Main determinant here is disposable income: Def: Y
d
= national income - taxes.
Write this: C = C(Y
d
). Means consumption is a function of disposable income,
positive function.
c) Consider what determines current account
Regard this as EX - IM
1) Yd saw increase in Yd makes consumers want consume more goods -
foreign as well as domestic. So imports rise, CA falls.
2) Real exchange rate: E P*/P
Recall this is relative price of representative basket in foreign country in terms
of representative home basket.
Real E affects CA because affects price of domestic goods relative to foreign.
For example: if EP*/P rises, means foreign products are more
expensive. IF change any element, will make more expensive
(E,P*,P)
increases exports, because your goods are cheaper and more attractive.
Affect imports: ambiguous: decreases number Jaguars will buy, because are
more expensive, but since each Jaguar is worth more $, is possible
that the total # of dollars being spent on importing jaguars rises.
We assume for now that CA will improve when real E rises.
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d) Summarize in equation of aggregate demand:
D = C(Y-T) + I + G + CA(EP*/P, Y-T)
or summarizing more:
D = D(EP*/P, Y-T, I, G)
Conclusions: Effect on D:
1) A real depreciation (rise in EP*/P) makes domestic goods cheaper relative
to foreign goods, so it shifts domestic and foreign spending from
foreign goods to domestic goods, so CA increases and aggregate D
increases.
2) A rise in income
a) raises consumption, which raises D
b) part of this consumption is on foreign goods, rise in imports, so CA falls,
which would tend to lower D.
Overall, increase in Y causes D to rise, but less so than in closed economy
where didnt consider CA.
Graph:
Idea: as increase Y, stimulates demand also, but part leaks away abroad because
imports rise. So is flatter than 45 degrees.
Note: start at positive intercept: because even if no income, still want to consume
something, and government expend constant at some level
regardless of Y.
Y
D
D(EP*/P,Y-T,I,G)
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2) Equilibrium in the goods market
Equilibrium condition: demand for goods and services equals amount being
produced: aggregate demand equals output.
Y = D(EP*/P,Y-T,I,G)
Graph this. Line for Y=D: 45 deg line at origin.
Graph:
Equilibrium is at Y1.
Equilibrating forces:
If at Y2: is D exceeds output. Depletes inventories of firms, so they produce
more. Y increases until equals D.
If at Y#, D is less than Y: Firms inventories build up, so produce less, until Y
equals D.
This should be familiar from previous macro classes. But now want to
consider relationship to exchange rate.
Y
D
D(EP*/P,Y-T,I,G)
D=Y
D+Y
Y1 Y2 Y3
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3) DD Curve
This is taking E as given. What if E rises (domestic currency depreciates)? Given
fixed prices, this will cause the real exchange rate to rise (home
goods become cheaper). This shifts D up, because $ depreciation
stimulates exports and dampens imports.
New equilibrium in goods market. Increased demand will deplete inventories and
cause firms to produce more.
As E rises (home currency depreciated), shifts up D-line, and raises equilibrium
output.
Cans summarize this in a curve. DD curve.
Graph:
So DD curve summarizes the effect on equilibrium goods market of change in Y.
Y
Y
D
E
D=Y
D+Y
Y2
Y2
Y1
Y1
D(E1,Y-T,I,G)
D
D
D(E2,Y-T,I,G)
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What shifts DD curve to right: (draw new double graph: shift D and Shift DD)
a) Increase in government expenditure: (example: need anti-missile shield)
Top graph: Increase D (aggregate demand) for any given output level
there is more demand. So Equilibrium Y will be higher, even if E is
same.
Bottom graph: equilibrium Y is higher for any given E. Therefore must
shift DD to right.
So Increases in G cause DD to shift to right.
b) Fall in taxes:
Top part: higher disposable income, so consumption rises, so D curve shift
out. And higher equilibrium Y.
Bottom part, higher equilibrium Y for any given E, so DD curve shift right.
c) increase in I: like G here
d) Increase in overall C function: If suddenly decide to consume more of
everything. Happened in US in 80s. Shifts D and DD like above.
e) Switch tastes away from foreign goods to home: tastes change. In 80s, when
oil price drops, tastes shift back to bigger US cars.
General principle: if shock increase aggregate Demand for a given E, will shift DD
to right.
Note distinction between movement along the curve and shifts in the curve.
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4) AA curve
Lets consider Asset market again now. Had been taking Y as given. But didnt
need to. Change in Y can affect Asset market.
What does change in Y do? Affects money demand. Increase output increases
money demand, because more goods want to buy.
Graph: shift out demand.
This increases the interest rate, because need to ration out the existing supply of
money. In foreign exchange market, makes current E fall (domestic
currency appreciates).
(Assume this is a temporary increase in Y, so no change here in E expected for
future.)
L(R,Y
2
)
Total returns
M
s
US
/P
US
U.S. real money supply
E
$/DM
R
$
0
L(R,Y
1
)
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So increase in Y, made currency depreciate in short run because of money market.
Can summarize this on graph of Y and E, as did for DD curve, but
deals with asset market instead, and is sloped other way.
Graph:
So change in E traces out AA, as move along it as Y changes.
What shifts AA right:
a) increase in money supply: Know shift MS line will cause the home currency
to depreciate. So for a given level of output, E is higher after the
rise in MS. Increase money supply shifts AA curve to right.
b) fall in price level: raises real money supply, so acts like case above. MS/P
line shifts, R falls, currency depreciates. So for given Y, E is
higher.
c) rise in expected exchange rate: recall this shifts foreign return line right and
makes current E rise.
d) rise in foreign interest rate: just like a above.
e) fall in money demand (for any given Y or R): shifts L curve left, R falls,
currency depreciates for any given Y. So AA shifts right.
A
A
Y
E
Y1 Y2
E1
E2
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5) Putting DD and AA curves together
Have two curves that show relation E and Y. Put together.
Asset market says given a Y, will have a certain E. Y implies a MD, which
implies an R, which implies a certain demand for the domestic
currency deposits, which by irp implies a certain E.
AA:Y MD R E

Goods market says given an E, will have a certain Y. E implies relative price of
home and foreign goods, implies a certain CA, implies a certain Y.
DD: E CA Y
Intersection represents equilibrium for an open economy.
Graph:
Point 1 is equilibrium. Suppose instead started off at point 2.
1) Jump up to AA to point 3: Currency is overvalued relative to what IRP says it
should be: given expected future E, expected depreciation is larger that
interest rate differential, so get out of $ deposits, lead to $ depreciation.
Jump up to AA, point 3.

2) Still below DD: goods market not in equilibrium. High value of domestic
currency makes home goods expensive: CA is low, means aggregate
demand < output, means will lower production and output falls; Move left.

3) As move left, are below AA again, so E depreciate some more, move up. (As
output fall, MD fall, R rise, current E must fall.) As move left, stay on AA
curve, because E keeps depreciating.
4)Forces at rest when at point 1.
A
A
D
D
Y
E
1
2
3