International Macroeconomics

Topic 5: Output and the Exchange Rate

UAH - ENI Degree, 2024-2025

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Contents
1 Theory 2
1.1 The DD curve: equilibrium in the goods and services market . . . . . . . . . . . . 2
1.2 The AA curve: equilibrium in the asset market . . . . . . . . . . . . . . . . . . . 7
1.3 Joint equilibrium in the goods and services market and in financial markets . . . 10

2 Practice and Exercises 15

2.1 Impact on Y and E of an expansionary monetary policy . . . . . . . . . . . . . . 15
2.2 Impact on Y and E of an expansionary fiscal policy . . . . . . . . . . . . . . . . . 15
2.3 Adjustment policies to restore full employment after shocks of different nature . . 15

3 Documents and Supplementary Materials 18

1 Theory
Objectives of the topic

• Understand how the goods market and the asset market interact in an open economy.

• Learn how to construct the DD curve (equilibrium in the goods market).

• Learn how to construct the AA curve (equilibrium in the asset market).

• Analyse how the joint equilibrium is achieved.

• Examine how the DD and AA curves shift under different shocks, in the short and long
run.

1.1 The DD curve: equilibrium in the goods and services market

The DD curve (from Demand for Domestic Output) represents the combinations of nominal
exchange rate E and output Y that ensure equilibrium in the goods market of an open economy.
The analysis starts from the notion that the nominal exchange rate can affect output through
its impact on net exports, and thus on aggregate demand.
To construct the DD curve, we rely on three pillars:

- The equilibrium identity Y = Z

- The role of the real exchange rate ε

- The Marshall-Lerner condition

Equilibrium in the goods and services market

The economy is in equilibrium in the goods market when total production of goods and services
(GDP, Y ) equals aggregate demand Z:

Y =Z

Aggregate demand is composed of consumption, investment, government spending, and net

exports:

Z = C(Y − T ) + I + G + XN

where:

- C(Y − T ): private consumption, an increasing function of disposable income.

- I: private investment, which we treat here as exogenous.

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 - G: government spending, also exogenous.

- XN : net exports, that is, exports minus imports.

The key variable in an open economy is XN , as it is the channel through which the exchange
rate affects equilibrium in the goods market.

Net exports and the real exchange rate

The net exports function is expressed as:

XN = X(ε, Y ∗ ) − M (ε, Y )

where:

- X: exports, depend positively on the real exchange rate ε and on the income of the rest
of the world Y ∗ .

- M : imports, depend negatively on ε and positively on domestic income Y .

P∗
- ε=E· P
: real exchange rate.

The real exchange rate ε measures the relative price of foreign goods in terms of domestic
goods. An increase in ε (i.e., a real depreciation) means that domestic goods become cheaper
for foreigners (improved external competitiveness) and foreign goods become more expensive
for domestic consumers (more expensive imports).

The Marshall-Lerner condition

The effect of a depreciation on net exports depends on the sensitivity of export and import
volumes to relative prices, that is, on price elasticities.

The Marshall-Lerner condition states that a real depreciation improves net exports if the sum
of the price elasticities (in absolute value) of demand for exports and imports is greater than
one:

ηX + |ηM | > 1

where:

- ηX : price elasticity of foreign demand for our exports.

- ηM : price elasticity of our demand for imports (negative, hence taken in absolute value).

If the Marshall-Lerner condition holds, a real depreciation:

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 - Increases export revenues (more volume sold, despite lower price).

- Reduces imports (less volume, despite higher price).

- Therefore, net exports increase, which raises aggregate demand and, in equilibrium, do-
mestic output.

If the Marshall-Lerner condition does not hold, the effect may be perverse: depreciation may
worsen the trade balance, because trade volumes respond little and the value in foreign currency
paid for imports may even increase. This is why it is essential: the positive slope of the DD
curve is based on the Marshall-Lerner condition being satisfied.

How does the nominal exchange rate E affect equilibrium?

Under the assumption that domestic and foreign prices (P and P ∗ ) are sticky in the short run,
an increase in E (nominal depreciation) raises the real exchange rate ε:

P∗
ε=E· ↑
P
This increases external competitiveness, and under the Marshall-Lerner condition, causes:

- Increase in X

- Decrease in M

- Improvement in XN

- Increase in Z

- Increase in Y

Thus, there is a positive relationship between E and Y , giving rise to a positively sloped DD
curve in the (E, Y ) space. See Figure 1.

Factors that shift the DD curve

The DD curve represents equilibrium in the goods market for each level of the nominal exchange
rate E, keeping other factors constant. Therefore, any change that affects aggregate demand
Z through a channel other than the exchange rate causes a shift in the DD curve.

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Figure 1: The slope of the DD curve is increasing: following an increase in the exchange rate
(E1 ), the external balance improves (∆XN > 0) and therefore aggregate demand (Z, in blue)
and final output (Y1 ); and vice versa (E2 < E0 ⇒ Y2 < Y0 ).

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 Factor DD Curve Explanation
Increases aggregate demand
↑ Government spending G To the right
directly.
Increases disposable income
↓ Taxes T To the right
⇒ consumption rises.
↑ Consumer or business Boosts consumption or
To the right
confidence investment.
Increases external demand for
↑ World GDP Y ∗ To the right
exports X.
Improves purchasing power
↑ Favourable terms of trade To the right
and trade balance.
↓ Government spending G To the left Reduces aggregate demand.
Reduces disposable income
↑ Taxes T To the left
and consumption.
↓ World GDP Y ∗ To the left Decreases external demand.
Reduces consumption and
↓ Confidence To the left
investment.

The J-curve effect

Although the previous logic seems clear, in practice a depreciation does not immediately im-
prove the trade balance. This phenomenon is known as the J-curve effect.
After a real depreciation:

- In the short run, import and export contracts are fixed in volume (or in foreign currency),
and consumers and firms take time to adjust their behaviour.

- Initially, more expensive imports increase the monetary value of purchases from abroad,
while export revenues barely change.

- This can lead to an initial worsening of XN .

Over time:

- Agents adjust quantities: export volumes increase, imports decrease.

- Eventually, if ML holds, the trade balance improves.

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The graphical effect of this process is an inverted J-shaped curve over time: initial drop in XN ,
followed by a recovery and sustained improvement.

Implication for the DD curve

- If a very short-term horizon is considered, the impact of a depreciation may be negative

for aggregate demand Z and for Y : the DD curve may not have a positive slope or may
even slope downward in some section.

- But if it is assumed that agents adjust quantities (positive elasticities) and the Marshall-
Lerner condition holds, then the positive slope is valid.

Therefore, the usual analysis of the DD curve assumes a short-run horizon long enough for the
J-curve effect to have passed.

1.2 The AA curve: equilibrium in the asset market

The AA curve represents the combinations of nominal exchange rate E and output Y that
ensure simultaneous equilibrium in the financial markets of an open economy. Specifically, it
arises from the interaction between the money market and the foreign exchange market, under
the assumptions of perfect capital mobility and flexible exchange rates.
Its name comes from the English term Asset Market Equilibrium, in contrast to the DD curve,
which captures equilibrium in the goods market.

To construct the AA curve, we start from two key relationships:

M
- Equilibrium in the money market: P
= L(R, Y )
E e −E
- Uncovered interest parity (UIP): R = R∗ + E

Equilibrium in the money market

M
In the money market, the real money supply P
must equal the real demand for money balances
L(R, Y ), where:

- M : nominal money supply, controlled by the central bank.

- P : domestic price level (assumed fixed in the short run).

- L(R, Y ): money demand, decreasing in the nominal interest rate R and increasing in
output Y .

This relationship allows us to determine the domestic equilibrium interest rate for each given
level of output.

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Interest Parity (UIP)

In a context of free capital mobility and perfect substitute assets, investors must be indifferent
between holding domestic or foreign assets. This requires that the expected return be equal in
both cases, which is formalised as:

Ee − E
R = R∗ +
E
where:

- R: domestic interest rate.

- R∗ : foreign interest rate.

- E: current nominal exchange rate.

- E e : expected nominal exchange rate in the future.

This equation implies that a country with a higher interest rate than abroad can only sustain
such a differential if its currency is expected to appreciate.

Construction of the AA curve

To construct the AA curve:

- Starting from a given level of Y , we use the money market equation to obtain the domestic
interest rate R that balances money supply and demand.

- With that R, we apply the UIP condition to determine the nominal exchange rate E.

We repeat this procedure for different values of Y , thereby obtaining the curve of all (E, Y )
pairs that maintain equilibrium in the financial markets.
Since Y ↑⇒ L(R, Y ) ↑⇒ R ↑, and given that R ↑⇒ E ↓ by UIP, the AA curve is downward
sloping in the (E, Y ) space.

Factors that shift the AA curve

The AA curve is constructed keeping the money supply, price level, foreign interest rate, and
expected exchange rate constant. If any of these factors change, the curve shifts:

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Figure 2: The AA curve is downward sloping: following an increase in income level (Y1 > Y0 ),
the interest rate in the money market rises (red R) and the exchange rate falls (E1 < E0 ); and
vice versa (Y2 < Y0 ⇒ E2 > E0 ).

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 Factor AA Curve Explanation
Reduces the interest rate R,
↑ Money supply M Upwards which depreciates the
currency (E ↑).
For a given Y , a lower R is
↓ Money demand Upwards
needed → E ↑.
↑ Expected exchange rate For a given R, a higher E is
Upwards e
Ee needed for R = R∗ + E E−E .
For a given R, a higher E is
↓ Foreign interest rate R∗ Upwards
required to maintain UIP.
Raises R, which appreciates
↓ Money supply M Downwards
the currency (E ↓).
Raises R for a given Y , and
↑ Money demand Downwards
by UIP, reduces E.
↓ Expected exchange rate Requires a lower current E to
Downwards
Ee maintain return equality.
A lower E is needed to offset
↑ Foreign interest rate R∗ Downwards
the higher foreign return.

Dynamics and intuition of the AA curve

The AA curve captures exchange rate movements resulting from very rapid adjustments in
financial markets. Unlike the DD curve, which reflects the dynamics of output (slower), the
AA curve is based on the assumption that assets are revalued almost instantly in response to
changes in expectations, monetary policy, or external conditions.

Therefore, the equilibrium between the DD curve (output) and the AA curve (financial market)
reflects the point where the economy adjusts both in real and nominal terms in the short run.

1.3 Joint equilibrium in the goods and services market and in fi-
nancial markets
Short-run equilibrium in an open economy with a flexible exchange rate is reached at the
intersection of the DD and AA curves. This point reflects the only pair of values (E, Y ) at
which:

- The goods market is in equilibrium: Y = Z

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 M
- The money market is in equilibrium: P
= L(R, Y )

- The uncovered interest parity (UIP) condition holds

The intersection of the DD and AA curves therefore provides the simultaneous solution to two
equations:

Y = Z(E, Y ) (DD curve)

E = E(R∗ , E e , M, P, Y ) (AA curve)

This equilibrium describes how the level of output and the nominal exchange rate are deter-
mined in the short run, given a particular economic policy and set of external conditions.

Interpretation of the equilibrium

In Figure ??, the intersection point defines the nominal exchange rate E0 and the level of output
Y0 that simultaneously ensure:

- That aggregate demand equals output.

- That domestic and international assets offer the same expected return.

- That the money market is in equilibrium.

If the economy is at a point outside this equilibrium, market forces will adjust E and/or Y
until the intersection is reached.

Example: monetary expansion

Suppose the central bank increases the money supply M . This shifts the AA curve upward,
because:

M
↑⇒ R ↓⇒ E ↑
P
In the new equilibrium:

- The nominal exchange rate is higher (depreciation).

- Output is higher, due to the improvement in net exports caused by the depreciation.

Figure 3 shows that the new equilibrium is reached at a point with higher Y and higher E,
reflecting the expansionary effect of monetary policy.

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Figure 3: Effect of a monetary expansion: shift of AA. An increase in M s reduces the interest
rate R, which in turn increases the exchange rate E given the initial income level Y0 .

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Example: fiscal expansion

If the government increases public spending or reduces taxes, the DD curve shifts to the right,
because:
Z ↑⇒ Y ↑

In this case:
- Output increases.

- The nominal exchange rate appreciates (lower E), due to the increase in money demand
generated by the higher level of output Y .

Figure 4: Effect of a fiscal expansion: shift of DD. An increase in G (or a reduction in T )

increases aggregate demand Z, which in turn increases Y1 > Y0 for the same initial exchange
rate E0 .

The result of a fiscal expansion is therefore a higher level of output but a lower nominal exchange
rate (appreciation), as seen in Figure 4.

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Interactions between DD and AA

The model allows us to analyse not only isolated policies, but also policy combinations (fiscal
and monetary) or the response to external shocks, such as changes in R∗ , E e , or Y ∗ .

- An expansionary fiscal policy can be offset by a contractionary monetary policy to stabilise

the exchange rate.

- A negative external demand shock would shift DD to the left, but could be counteracted
with a monetary expansion (AA shifts upward).

- A currency confidence crisis (rise in E e ) shifts AA upward, generating depreciation pres-

sure without affecting DD in the short run.

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2 Practice and Exercises

2.1 Impact on Y and E of an expansionary monetary policy

According to the theory of the DD-AA model, represent graphically and explain what happens
when the central bank decides to implement an expansionary monetary policy, in the following
scenarios:

- Temporary

- Permanent

- What will happen in the long run?

2.2 Impact on Y and E of an expansionary fiscal policy

According to the theory of the DD-AA model, represent graphically and explain what happens
when the government decides to implement an expansionary fiscal policy, in the following
scenarios:

- Temporary

- Permanent

- What will happen in the long run?

2.3 Adjustment policies to restore full employment after shocks of

different nature
For each of the following scenarios, use the DD-AA model, represent it graphically, analyse
what happens, and answer the questions posed.

1. Negative external demand shock

Context: A global recession reduces demand for exports.

1. Which curve shifts? In which direction?

2. What happens to the exchange rate and output in the new short-run equilibrium?

3. Is an output gap generated? What type?

4. Which economic policy (monetary or fiscal) could return the economy to Yn ?

5. What would be the effect of such a policy on the exchange rate?

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2. Increase in the foreign interest rate R∗

Context: The Federal Reserve raises interest rates and the interest rate differential widens.

1. Which curve is affected? How does it shift?

2. How does the exchange rate change? And output?

3. What is the appropriate response to return to full employment?

4. Which policy is faster and more effective in this context?

3. Increase in domestic public spending

Context: The government launches an ambitious infrastructure plan.

1. Which curve shifts and in which direction?

2. What happens to the exchange rate?

3. Could excessive appreciation occur, harming the external sector?

4. What monetary policy could accompany the fiscal one to stabilise the exchange rate?

4. Confidence crisis: increase in E e

Context: Markets fear a future devaluation → E e rises.

1. Which curve is affected? What effect does it have on E and Y ?

2. Is an output gap generated?

3. What policy could counteract this shock?

4. Does defending the currency come at a cost in terms of output?

5. Mixed shock: fall in Y ∗ and monetary contraction

Context: International economic crisis and tightening of monetary policy.

1. Which curves shift and in which direction?

2. What happens to the equilibrium? What happens to E and Y ?

3. What policy combination could bring the economy back to Yn without excessive currency
depreciation?

4. What would happen if the central bank prioritises exchange rate stability?

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6. Increase in international prices P ∗

Context: Foreign prices rise significantly more than domestic ones.

1. What impact does this have on the real exchange rate?

2. How does this affect competitiveness and net exports?

3. Which curve is affected and in what direction?

4. What are the consequences for output and the nominal exchange rate?

5. Is economic policy intervention necessary, or does the system adjust automatically?

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3 Documents and Supplementary Materials
⟲ Reference Textbook

- Paul R. KRUGMAN, Maurice OBSTFELD and Marc J. MELITZ, International

Economics. Theory and Policy, 12th Edition. Global Edition BD, Pearson, 2023.
Chapter 17.

⟲ Supporting Notes

- Quantity theory of money

- Saving-investment identity
- Marshall-Lerner condition
- Investment in the DD-AA model
- Class graphs

⟲ Practice Exercises

- Monetary policy: effects on Y and E.

- Fiscal policy: effects on Y and E.
- Adjustment policies to restore full employment after shocks of different nature

⟲ Suggested Readings:

⋆ A User’s Guide to Restructuring the Global Trading System, Stephen Miran.

⋆ The Miran Doctrine: Trump’s Plan to Disrupt Globalisation, El Grand Continent.
⋆ The Trump Doctrine: These Are the Measures Backed by His Chief Economic Ad-
viser, Agenda Pública.

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