International Finance: Theory & Policy,

12/e, Global Edition

Twelfth Edition, Global Edition

Chapter 6
Output and the
Exchange Rate in the
Short Run

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Learning Objectives (1 of 2)
6.1 Explain the role of the real exchange rate in
determining the aggregate demand for a country’s
output.
6.2 See how an open economy’s short-run
equilibrium can be analyzed as the intersection of
an asset market equilibrium schedule (AA) and an
output market equilibrium schedule (DD).
6.3 Understand how monetary and fiscal policies
affect the exchange rate and national output in the
short run.

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Learning Objectives (2 of 2)
6.4 Describe and interpret the long-run effects of
permanent macroeconomic policy changes.
6.5 Explain the relationship among macroeconomic
policies, the current account balance, and the
exchange rate.

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Preview
• Determinants of aggregate demand in the short run
• A short-run model of output markets
• A short-run model of asset markets
• A short-run model for both output markets and asset
markets
• Effects of temporary and permanent changes in
monetary and fiscal policies
• Adjustment of the current account over time
• IS-LM model

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Introduction
• Long-run models are useful when all prices of
inputs and outputs have time to adjust.
• In the short run, some prices of inputs and outputs
may not have time to adjust, due to labor
contracts, costs of adjustment, or imperfect
information about willingness of customers to pay
at different prices.
• This chapter builds on the short-run and long-run
models of exchange rates to explain how output is
related to exchange rates in the short run.
– It shows how macroeconomic policies can
affect production, employment, and the current
account. Copyright © 2023 Pearson Education, Ltd.
Determinants of Aggregate Demand (1 of 3)
• Aggregate demand is the aggregate amount of goods
and services that individuals and institutions are willing to
buy:

1. consumption expenditure
2. investment expenditure
3. government purchases
4. net expenditure by foreigners: the current account

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Determinants of Aggregate Demand (2 of 3)
• Determinants of consumption expenditure include:
– Disposable income: income from production
(Y) minus taxes (T).
– More disposable income means more
consumption expenditure, but consumption
typically increases less than the amount that
disposable income increases.
– Real interest rates may influence the amount
of saving and spending on consumption goods,
but we assume that they are relatively
unimportant here.
– Wealth may also influence consumption
expenditure, but we assume that
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Determinants of Aggregate Demand (3 of 3)
• Determinants of the current account include:
– Real exchange rate: prices of foreign products
relative to the prices of domestic products, both
measured in WP *
domestic
P
currency:
▪ As the prices of foreign products rise relative to
those of domestic products, expenditure on
domestic products rises, and expenditure on
foreign products falls.
– Disposable income: more disposable income
means more expenditure on foreign products
(imports).

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Table 6.1 Factors Determining the
Current Account

Change Effect on Current Account, CA

EP *
Real exchange rate,  CA C A upward arrow

P
start fraction E P asterisk over P end fraction upward arrow

EP * CA 
Real exchange rate, 
start fraction E P asterisk over P end fraction downward arrow
C A downward arrow

Disposable income, Y d  Y super d upward arrow

CA 
C A downward arrow

d
Disposable income, Y  Y super d downward arrow

CA 
C A upward arrow

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How Real Exchange Rate Changes Affect
the Current Account (1 of 2)
• The current account measures the value of exports relative to
the value
of CA EX  IM .
imports:
EP *
– When the real exchange rises, the
rate P
prices
of foreign products rise relative to the prices of domestic
products.
1. The volume of exports that are bought by foreigners rises.
2. The volume of imports that are bought by domestic
residents falls.
3. The value of imports in terms of domestic products rises: the
value/price of imports rises, since foreign products are more
valuable/expensive.

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How Real Exchange Rate Changes Affect
the Current Account (2 of 2)
• If the volumes of imports and exports do not change much, the
value effect may dominate the volume effect when the real
exchange rate changes.
– For example, contract obligations to buy fixed amounts of
products may cause the volume effect to be small.
• However, evidence indicates that for most countries the
volume effect dominates the value effect after 1 year or less.
• Let’s assume for now that a real depreciation leads to an
increase in the current account: the volume effect dominates
the value effect.

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Figure 6.1 Aggregate Demand as a
Function of Output

EP *
Aggregate demand is a function of the real exchange rate , disposable
P
income (Y  T ), investment demand (I), and government spending (G). If all
other factors remain unchanged, a rise in output (real income), Y, increases
aggregate demand. Because the increase in aggregate demand is less than the
increase in output, the slope of the aggregate demand function is less than 1 (as
indicated by its position within the 45-degree angle).
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Determinants of Aggregate Demand (1 of 4)
• Determinants of the current account include:
– Real exchange rate: an increase in the real
exchange rate increases the current account.
– Disposable income: an increase in the
disposable income decreases the current
account.

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Determinants of Aggregate Demand (2 of 4)
• For simplicity, we assume that exogenous political
factors determine government purchases G and
the level of taxes T.
• For simplicity, we currently assume that
investment expenditure I is determined by
exogenous business decisions.
– A more complicated model shows that
investment depends on the cost of spending or
borrowing to finance investment: the interest
rate.

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Determinants of Aggregate Demand (3 of 4)
• Aggregate demand is therefore expressed as:
 EP  
D C Y  T   I  G  CA  ,Y  T 
 P 
– where C Y  T  is consumption expenditure as a
function of disposable income,
– I + G is investment expenditure and government purchases
(both exogenous), and
 EP  
– CA  ,Y  T  is the current account as a function of the real
 P 
exchange rate and disposable income.
 EP  
• Or more D D  ,Y  T , I,G 
simply:  P 

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Determinants of Aggregate Demand (4 of 4)
• Determinants of aggregate demand include:
– Real exchange rate: an increase in the real exchange
rate increases the current account, and therefore
increases aggregate demand of domestic products.
– Disposable income: an increase in the disposable
income increases consumption expenditure, but
decreases the current account.
▪ Since consumption expenditure is usually greater
than expenditure on foreign products, the first effect
dominates the second effect.
▪ As income increases for a given level of taxes,
aggregate consumption expenditure and aggregate
demand increase by less than income.

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Short-Run Equilibrium for Aggregate
Demand and Output
• Equilibrium is achieved when the value of output
and income from production Y equals the value of
aggregate demand D

 EP  
Y D  ,Y  T , I,G 
 P 

– where aggregate demand is a function of the

real exchange rate, disposable income,
investment expenditure, and government
purchases.

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Figure 6.2 The Determination of Output in
the Short Run

In the short run, output Y 1 (point 1), where

settles at 1 aggregate
demand D , equals aggregate Y 1.
, output,
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Short-Run Equilibrium and the Exchange
Rate: DD Schedule (1 of 2)
• How does the exchange rate affect the short-run
equilibrium of aggregate demand and output?
• With fixed domestic and foreign levels of average
prices, a rise in the nominal exchange rate makes
foreign goods and services more expensive relative to
domestic goods and services.
• A rise in the nominal exchange rate (a domestic
currency depreciation) increases aggregate demand of
domestic products.
• In equilibrium, production will increase to match the
higher aggregate demand.

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Figure 6.3 Output Effect of a Currency
Depreciation with Fixed Output Prices

A rise in the exchange rate E 1 to E 2 (a currency

from
raises aggregate demand to Aggregate depreciation)
(E 2 ) and output
demand
Y 2 , all else to
equal. Copyright © 2023 Pearson Education, Ltd.
 Figure 6.4 Deriving the DD Schedule

The DD schedule (shown in the lower panel) slopes upward because a rise in the
exchange rate from E 1 to E 2 all else equal, causes output to rise from Y 1 to Y 2 .

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Short-Run Equilibrium and the Exchange
Rate: DD Schedule (2 of 2)
DD schedule
• shows combinations of output and the exchange
rate at which the output market is in short-run
equilibrium (such that aggregate demand =
aggregate output).
• slopes upward because a rise in the exchange rate
causes aggregate demand and aggregate output
to rise.

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Shifting the DD Curve (1 of 3)
• Changes in the exchange rate cause movements
along a DD curve. Other changes cause it to shift:

1. Changes in G: more government purchases

cause higher aggregate demand and output in
equilibrium. Output increases for every exchange
rate: the DD curve shifts right.
2. Changes in T: lower taxes generally increase
consumption expenditure, increasing aggregate
demand and output in equilibrium for every
exchange rate: the DD curve shifts right.

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Figure 6.5 Government Demand and the
Position of the DD Schedule

A rise in government demand G1 to G 2 raises output at every level

of
fromexchange rate. The change therefore
the shifts DD to
the right.
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Shifting the DD Curve (2 of 3)
3. Changes in I: higher investment expenditure
shifts the DD curve right.
4. Changes in P: higher domestic prices make
domestic output more expensive compared to
foreign output and reduce net export demand,
shifting the DD curve left.
5. Changes in P*: higher foreign prices make
domestic output less expensive compared to
foreign output and increase net export demand,
shifting the DD curve right.

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Shifting the DD Curve (3 of 3)
6. Changes in C: willingness to consume more and
save less shifts the DD curve right.
7. Changes in demand of domestic goods
relative to foreign goods: willingness to
consume more domestic goods relative to foreign
goods shifts the DD curve right.

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Short-Run Equilibrium in Asset Markets (1 of 2)
• Consider two sets of asset
markets:
1. Foreign exchange markets
– interest parity represents R R 

E e
E 
E
equilibrium:
2. Money
market
– Equilibrium occurs when the quantity of real monetary
assets supplied matches the quantity of real monetary
MS
assets  L R,Y 
P
demanded:
– A rise in income from production causes the demand of
real monetary assets to increase.

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Figure 6.6 Output and the Exchange Rate
in Asset Market Equilibrium

For the asset (foreign exchange and money) markets to remain in

equilibrium, a rise in output must be accompanied by an appreciation
of the currency, all else equal.
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Short-Run Equilibrium in Asset Markets (2 of 2)

• When income and production increase,

– demand of real monetary assets increases,
– leading to an increase in domestic interest
rates,
– leading to an appreciation of the domestic
currency.
• Recall that an appreciation of the domestic
currency is represented by a fall in E.
• When income and production decrease, the
domestic currency depreciates and E rises.

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Short-Run Equilibrium in Asset Markets:
AA Curve
• The inverse relationship between output and
exchange rates needed to keep the foreign
exchange markets and the money market in
equilibrium is summarized as the AA curve.

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Figure 6.7 The AA Schedule

The asset market equilibrium schedule (AA) slopes downward because a

rise in output from Y 1 to Y 2 , all else equal, causes a rise in the home
interest rate and a domestic currency appreciation from E 1 to E 2 .

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Shifting the AA Curve (1 of 3)
1. Changes M s : an increase in the money
in supply
reduces interest rates in the short run, causing
the domestic currency to depreciate (a rise in E)
for every Y: the AA curve shifts up (right).

2. Changes in P: An increase in the level of

average domestic prices decreases the supply of
real monetary assets, increasing interest rates,
causing the domestic currency to appreciate (a
fall in E): the AA curve shifts down (left).

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Shifting the AA Curve (2 of 3)
3. Changes E e : if market participants
in
domestic currencyexpect the
to depreciate in the future,
foreign currency deposits become more
attractive, causing the domestic currency to
depreciate (a rise in E): the AA curve shifts up
(right).
4. Changes in R * : An increase in the foreign
interest rates makes foreign currency deposits
more attractive, leading to a depreciation of the
domestic currency (a rise in E): the AA curve
shifts up (right).

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Shifting the AA Curve (3 of 3)
5. Changes in the demand of real monetary
assets: if domestic residents are willing to hold a
lower amount of real money assets and more
non-monetary assets, interest rates on
nonmonetary assets would fall, leading to a
depreciation of the domestic currency (a rise in
E): the AA curve shifts
up (right).

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Putting the Pieces Together: the DD and
AA Curves (1 of 2)
• A short-run equilibrium means a nominal
exchange rate and level of output such that

1. equilibrium in the output markets holds:

aggregate demand equals aggregate output.
2. equilibrium in the foreign exchange markets
holds: interest parity holds.
3. equilibrium in the money market holds: the
quantity of real monetary assets supplied equals
the quantity of real monetary assets demanded.

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Putting the Pieces Together: the DD and
AA Curves (2 of 2)
• A short-run equilibrium occurs at the intersection
of the DD and AA curves:
– output markets are in equilibrium on the DD
curve
– asset markets are in equilibrium on the AA
curve

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Figure 6.8 Short-Run Equilibrium: The
Intersection of DD and AA

The short-run equilibrium of the economy occurs at point 1, where

the output market (whose equilibrium points are summarized by the
DD curve) and the asset market (whose equilibrium points are
summarized by the AA curve) simultaneously clear.

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Figure 6.9 How the Economy Reaches Its
Short-Run Equilibrium

Because asset markets adjust very quickly, the exchange rate jumps
immediately from point 2 to point 3 on AA. The economy then moves
to point 1 along AA as output rises to meet aggregate demand.

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Temporary Changes in Monetary and
Fiscal Policy
• Monetary policy: policy in which the central bank
influences the supply of monetary assets.
– Monetary policy is assumed to affect asset markets
first.
• Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of government
purchases and taxes.
– Fiscal policy is assumed to affect aggregate
demand and output first.
• Temporary policy changes are expected to be reversed
in the near future and thus do not affect expectations
about exchange rates in the long run.
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Temporary Changes in Monetary Policy
• An increase in the quantity of monetary assets
supplied lowers interest rates in the short run,
causing the domestic currency to depreciate (E
rises).
– The AA shifts up (right).
– Domestic products relative to foreign products
are cheaper, so that aggregate demand and
output increase until a new short-run
equilibrium is achieved.

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Figure 6.10 Effects of a Temporary
Increase in the Money Supply

By AA1 upward, a temporary increase in the money

shifting supply
causes a currency depreciation and a rise in
output.
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Temporary Changes in Fiscal Policy
• An increase in government purchases or a
decrease in taxes increases aggregate
demand and output in the short run.
– The DD curve shifts right.
– Higher output increases the demand for
real monetary assets,
▪ thereby increasing interest rates,
▪ causing the domestic currency to
appreciate (E falls).

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Figure 6.11 Effects of a Temporary Fiscal
Expansion

By DD1 to the right, a temporary fiscal expansion

shifting causes a
currency appreciation and a rise in
output.
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Policies to Maintain Full Employment (1 of 3)
• Resources used in the production process can either be
over-employed or underemployed.
• When resources are used effectively and sustainably,
economists say that production is at its potential or natural
level.
– When resources are not used effectively, resources are
underemployed: high unemployment, few hours worked,
idle equipment, lower than normal production of goods
and services.
– When resources are not used sustainably, labor is over-
employed: low unemployment, many overtime hours,
over-utilized equipment, higher than normal production
of goods and services.

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Figure 6.12 Maintaining Full Employment after a
Temporary Fall in World Demand for Domestic Products

A temporary fall in world demand DD1 to DD 2 , reducing output Y 1 to Y 2

shifts
and causing the currency to E 1 to E 2 from
(point 2). Temporary
depreciate
expansion canfromrestore full employment (point 1) by fiscal
shifting the DD schedule
back to its
original position. Temporary monetary expansion can restore full employment
(point
by 3) AA1 to AA2 . The two policies differ in their exchange rate effects:
shifting
fiscal Thecurrency to its
policy restores the (E 1 ), whereas the
previous valuethe currency to depreciate
policy causes E3. monetary
further, to
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 Figure 6.13 Policies to Maintain Full
Employment After a Money Demand Increase

After a temporary money demand increase (shown by the shift from AA1 to AA2 ),
either an increase in the money supply or temporary fiscal expansion can be used to
maintain full employment. The two policies have different exchange rate effects: The
monetary policy restores the exchange rate back to E 1, whereas the fiscal policy
leads to greater appreciation E .
3

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Policies to Maintain Full Employment (2 of 3)
• Policies to maintain full employment may seem easy in
theory, but are hard in practice.

1. We have assumed that prices and expectations do not

change, but people may anticipate the effects of policy
changes and modify their behavior.
– Workers may require higher wages if they expect
overtime and easy employment, and producers may
raise prices if they expect high wages and strong
demand due to monetary and fiscal policies.
– Fiscal and monetary policies may therefore create price
changes and inflation, thereby preventing high output
and employment: inflationary bias.

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Policies to Maintain Full Employment (3 of 3)
2. Economic data are difficult to measure and to understand.
– Policy makers cannot interpret data about asset markets and
aggregate demand with certainty, and sometimes they make
mistakes.
3. Changes in policies take time to be implemented and to affect the
economy.
– Because they are slow, policies may affect the economy after
the effects of an economic change have dissipated.

4. Policies are sometimes influenced by political or bureaucratic

interests.

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Permanent Changes in Monetary and
Fiscal Policy
• “Permanent” policy changes are those that are assumed
to modify people’s expectations about exchange rates in
the long run.

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Permanent Changes in Monetary Policy
• A permanent increase in the quantity of monetary
assets supplied has several effects:
– It lowers interest rates in the short run and
makes people expect future depreciation of the
domestic currency, increasing the expected
rate of return on foreign currency deposits.
– The domestic currency depreciates (E rises)
more than is the case when expectations are
constant (Econ Chapter 14/Finance Chapter 3
results).
– The AA curve shifts up (right) more than is the
case when expectations are held constant.
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Figure 6.14 Short-Run Effects of a
Permanent Increase in the Money Supply

A permanent increase in the money supply, AA1 to AA2

which shifts
and moves the economy from point 1 to point 2, has stronger effects
on the exchange rate and output than an equal temporary increase,
which moves the economy only to point 3.

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Effects of Permanent Changes in
Monetary Policy in the Long Run
• With employment and hours above their normal
levels, there is a tendency for wages to rise over
time.
• With strong demand for goods and services and
with increasing wages, producers have an
incentive to raise prices over time.
• Both higher wages and higher output prices are
reflected in a higher level of average prices.
• What are the effects of rising prices?

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Figure 6.15 Long-Run Adjustment to a
Permanent Increase in the Money Supply

After a permanent money supply increase, a steadily increasing price

level shifts the DD and AA schedules to the left until a new long-run
equilibrium (point 3) is reached.

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Effects of Permanent Changes in Fiscal
Policy (1 of 2)
• A permanent increase in government purchases or
reduction in taxes
– increases aggregate demand
– makes people expect the domestic currency to
appreciate in the short run due to increased
aggregate demand, thereby reducing the expected
rate of return on foreign currency deposits and
making the domestic currency appreciate.
• The first effect increases aggregate demand of
domestic products, the second effect decreases
aggregate demand of domestic products (by making
them more expensive).

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Effects of Permanent Changes in Fiscal
Policy (2 of 2)
• If the change in fiscal policy is expected to be
permanent, the first and second effects exactly offset
each other, so that output remains at its potential or
natural (or long run) level.
• We say that an increase in government purchases
completely crowds out net exports, due to the effect
of the appreciated domestic currency.

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 Figure 6.16 Effects of a Permanent Fiscal
Expansion

Because a permanent fiscal expansion changes exchange rate

expectations,
it DD1 to the right. The effect on
AA1 leftward as it
shifts shifts output
(point 2) is nil if the economy starts in long-run equilibrium. A
comparable temporary fiscal expansion, in contrast, would leave the
economy at point 3.
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Macroeconomic Policies and the Current
Account (1 of 4)
• To determine the effect of monetary and fiscal policies
on the current account,
– derive the XX curve to represent the combinations
of output and exchange rates at which the current
account is at its desired level.
• As income from production increases, imports increase
and the current account decreases when other factors
remain constant.
• To keep the current account at its desired level, the
domestic currency must depreciate as income from
production increases: the XX curve should slope
upward.

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Figure 6.17 How Macroeconomic Policies
Affect the Current Account

Along the curve XX, the current account is constant at the level CA =
X. Monetary expansion moves the economy to point 2 and thus raises
the current account balance. Temporary fiscal expansion moves the
economy to point 3, while permanent fiscal expansion moves it to
point 4; in either case, the current account balance falls.
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Macroeconomic Policies and the Current
Account (2 of 4)
• The XX curve slopes upward but is flatter than the
DD curve.
– DD represents equilibrium values of aggregate
demand and domestic output.
– As domestic income and production increase,
domestic saving increases, which means that
aggregate demand (willingness to spend) by
domestic residents does not rise as rapidly
as income and production.

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Macroeconomic Policies and the Current
Account (3 of 4)
– As domestic income and production increase, the
domestic currency must depreciate to entice
foreigners to increase their demand of domestic
products in order to keep the current account (only
one component of aggregate demand) at its
desired level—on the XX curve.
– As domestic income and production increase, the
domestic currency must depreciate more rapidly
to entice foreigners to increase their demand of
domestic products in order to keep aggregate
demand (by domestic residents and foreigners)
equal to production—on the DD curve.

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Macroeconomic Policies and the Current
Account (4 of 4)
• Policies affect the current account through their
influence on the value of the domestic currency.
– An increase in the quantity of monetary assets
supplied depreciates the domestic currency
and often increases the current account in the
short run.
– An increase in government purchases or
decrease in taxes appreciates the domestic
currency and often decreases the current
account in the short run.

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Value Effect, Volume Effect, and the
J-Curve (1 of 3)
• If the volume of imports and exports is fixed in the short run, a
depreciation of the domestic currency
– will not affect the volume of imports or exports,
– but will increase the value/price of imports in domestic currency
and decrease the current account:

CA  EX  IM .

– The value of exports in domestic currency does not change.

• The current account could immediately decrease after a currency
depreciation, then increase gradually as the volume effect begins to
dominate the value effect.

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Figure 6.18 The J-Curve

The J-curve describes the time lag with which a real currency
depreciation improves the current account.

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Value Effect, Volume Effect, and the
J-Curve (2 of 3)
• Pass-through from the exchange rate to import prices
measures the percentage by which import prices
change when the value of the domestic currency
changes by 1%.
• In the DD-AA model, the pass-through rate is 100%:
import prices in domestic currency exactly match a
depreciation of the domestic currency.
• In reality, pass-through may be less than 100% due to
price discrimination in different countries.
– Firms that set prices may decide not to match
changes in the exchange rate with changes in
prices of foreign products denominated in domestic
currency.
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Value Effect, Volume Effect, and the
J-Curve (3 of 3)
• If prices of foreign products in domestic currency do
not change much because of a pass-through rate less
than 100%, then
– the value of imports will not rise much after a
domestic currency depreciation, and the current
account will not fall much, making the J-curve effect
smaller.
– the volume of imports and exports will not adjust
much over time, since domestic currency prices do
not change much.
• Pass-through of less than 100% dampens the effect of
depreciation or appreciation on the current account.

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Global Value Chains and Exchange Rate
Effects of Export and Import Prices

• Some imported intermediate goods become part of

goods that are exported, leading to complex global
value chains in which multiple countries produce
portions of the value added of final products.
• For many countries, imported value accounts for a
significant portion of the gross value of exports
(backward linkages).
– A country’s exports may go on to be included in
exports from other countries (forward linkages).
• Backward and forward linkages tend to dampen the
effects of currency depreciations by creating offsetting
forces.

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Figure 6.19 Import Content of Exports for Selected
Countries in the European Union, 2005–2016

Imported value added can account for a significant fraction of the

value of exports.

Source: OECD.

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The Liquidity Trap (1 of 3)
• During the Great Depression of the 1930s, the nominal
interest rate hit zero in the United States, and the country
found itself in a liquidity trap.
• Once an economy’s nominal interest rate falls to zero, a
central bank experiences difficulty lowering it any further.
– At negative nominal interest rates, people find holding
money preferable to bonds.
– Central banks may want to avoid the zero lower bound
(ZLB) on the nominal interest rate to keep monetary
expansion as an option.
– Starting in 2014, some major central banks have pushed
nominal interest rates into slightly negative territory.

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The Liquidity Trap (2 of 3)
• The dilemma facing a central bank when the economy is in a liquidity
trap slowdown can be seen by considering the interest parity
condition when the domestic interest rate R = 0,

 
R 0 R *  E e  E / E.

• Assume for the moment that the expected future exchange rate,
E e , is fixed.

• Suppose the central bank raises the domestic money supply so as

to depreciate the currency temporarily
– that is, to raise E today but return the exchange rate to
the level E e later.

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The Liquidity Trap (3 of 3)
• The interest parity condition shows that E cannot rise once R =
0 because the interest rate would have to become negative.
• Instead, despite the increase in the money supply, currency
cannot depreciate further and the exchange rate remains
steady at

E E e / 1  R * .

• At an interest rate of R = 0, people are indifferent between

bonds and money as both yield a zero nominal rate of return.
– An increase in the money supply has no effect on the
economy!

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Figure 6.20 A Low-Output Liquidity Trap

At point 1, output is below its full employment level. Because

exchange rate
expectation E e are fixed, however, a monetary expansion will
sAA to the right, merely
leaving shift
the initial equilibrium point the same. The
horizontal stretch of AA gives rise to the liquidity trap.

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Summary (1 of 3)
1. Aggregate demand is influenced by disposable
income and the real exchange rate.
2. The DD curve shows combinations of exchange
rates and output where aggregate demand =
aggregate output.
3. The AA curve shows combinations of exchange
rates and output where the foreign exchange
markets and money market are in equilibrium.

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Summary (2 of 3)
4. In the DD-AA model, we assume that a
depreciation of the domestic currency leads to an
increase in the current account and aggregate
demand.
5. But reality is more complicated, and the
J-curve shows that the value effect at first
dominates the volume effect.

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Summary (3 of 3)
6. A temporary increase in the money supply is
predicted to increase output and depreciate the
domestic currency.
7. A permanent increase does both to a larger degree in
the short run, but in the long run output returns to its
normal level.
8. A temporary increase in government purchases is
predicted to increase output and appreciate the
domestic currency.
9. A permanent increase in government purchases is
predicted to completely crowd out net exports, and
therefore to have no effect on output.
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Figure 6A1.1 Change in Output and
Saving

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Table 6A2.1 Estimated Price Elasticities for
International Trade in Manufactured Goods

Source: Estimates come from Jacques R. Artus and Malcolm D. Knight, Issues in the
Assessment of the Exchange Rates of Industrial Countries. Occasional Paper 29.
Washington, D.C.: International Monetary Fund, July 1984, table 4. Dashes indicate
unavailable estimates.

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