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3543 Fiscal and Financial System in Japan A
/ KC3002 International Finance
Fall 2012
Lecture 9(Dec 11)
Open Economy Macroeconomic Model:
DD-AA Model
Hideyuki IWAMURA
Faculty of International Studies
Model of the goods market
Inputs
(Exogenously given
variables)
Output
(Endogenously
determined variable)
Exchange rate
Investment
Government
expenditure
45 degree
line model
GDP (Income)
US Income
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Aggregate demand for goods/services
Aggregate demand for goods/services consists of
the following types of demands:
1. Consumption demand ( C )
Household’s demand for domestic goods/services
2. Investment demand ( I )
Firm’s demand for domestic goods/services
3. Government demand ( G )
Government’s demand for domestic goods/services
4. Trade Balance ( TB )
Net foreign demand for domestic goods/services
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Components of aggregate demand
Consumption demand C
＋ GDP(income)
Y
Expectation
Investment demand
I
Interest rate
Aggregate demand
Government demand G
Policy
－ GDP(income)
Net foreign demand
TB
＋
US GDP
＋ Exchange rate
Y
Y∗
E
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Components of aggregate demand
Aggregate
demand
＋
Y
＋
Y∗
＋
E0
＋
I
Increases in E0 , I, G, Y
∗
Aggregate demand
given E0 , I, G, Y ∗
＋
G
Y
Changes in E0 , I, G, Y ∗ shifts the demand schedule upward or
downward.
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Equilibrium in the market for goods
Aggregate demand
Aggregate supply
Aggregate supply
Output exceeds demand.
Firms have unplanned
inventories, and
decrease output.
Aggregate demand
given the level of E0 ,I, G, Y∗
Demand exceeds output.
Firms meet the excess
demand out of
inventories, and increase
output.
Equilibrium GDP
45°
Y
Y0
Y2
Y1
Given the level of investment, government expenditure, the US GDP
and exchange rate, the Japan’s GDP is determined at a level where the
aggregate demand are equal to the aggregate supply.
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Changes in the equilibrium GDP(1)
An increase in the yen/dollar exchange rate raises the net export
demand for the Japanese goods/services at every level of output.
An increase in the yen/dollar exchange rate raises the aggregate
demand at every level of output.
Aggregate demand ( E0 = 80 )
Aggregate demand ( E0 = 78 )
Y0
Y1
Y
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Changes in the equilibrium GDP(2)
An increase in investment demand raises the aggregate demand for
the Japan’s goods/services at every level of output.
Aggregate demand ( I= 150 )
Aggregate demand ( I= 100 )
Y0
Y1
Y
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Changes in the equilibrium GDP(3)
An increase in government expenditure raises the aggregate demand
for the Japan’s goods/services at every level of output.
Aggregate demand ( G= 70 )
Aggregate demand ( G= 50 )
Y0
Y1
Y
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Changes in the equilibrium GDP(4)
An increase in the US GDP raises the US demand for the Japanese
goods/services at every level of Japan’s output.
An increase in the US GDP raises the aggregate demand for the
Japanese goods/services at every level of Japan’s output.
Aggregate demand ( Y∗ = 1100 )
Aggregate demand ( Y∗ = 1000 )
Y0
Y1
Y
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OPEN ECONOMY MACROECONOMIC
MODEL: THE DD-AA MODEL
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Combining the three models
US GDP
Investment
Government
Goods
market
Current
exchange rate
Expected future
exchange rate
FX
market
$Interest rate
GDP(income)
¥Interest rate
¥price level
Money
market
¥money stock
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Simultaneous equilibrium in three markets
Goods
market
Current
exchange rate
FX
market
GDP(income)
¥Interest rate
Money
market
The three variables are determined so that all the markets
are in equilibrium simultaneously.
What is the value of E0 , i, Y where all the markets are in
equilibrium simultaneously?
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DD-AA approach to the equilibrium
Find the pairs of E0 and Y
which equilibrate the goods market.
Goods
market
DD set
E0
FX
market
Y
i
Money
market
Find the pairs of E0 and Y
which equilibrate the FX market
and the money market
simultaneously.
AA set
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Short-run
macroeconomic
equilibrium
Set of pairs of E0 and Y
which equilibrate
the goods market
E0
D
A
Set of pairs of E 0 and Y
which equilibrate
the FX and money
markets
E0
A
D
Y
Y
The short-run macroeconomic equilibrium where the
goods, FX, and money markets are in equilibrium
simultaneously, with the product prices constant.
Why does the DD schedule slope upward?
Why does the AA schedule slope downward?
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Aggregate demand
given E10
Deriving the DD
curve
Aggregate demand
given E00
Suppose E00 and Y0
equilibrate the goods market.
An increase in E0 raises the
aggregate demand.
E0
Y0
Y1
A larger Y meets the larger
demand.
Y
Set of pairs of E0 and Y
which equilibrate
the goods market
1
0
0
0
E
E
Y0
Y1
Y
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Re , i
Deriving the AA
curve
Given Y1
Given
L,
M
P
Y0
E0
Set of pairs of E0 and Y
which equilibrate
the FX and money
markets
Suppose E20 and Y0
equilibrate the FX and money
markets.
E20
E30
An increase in Y raises the
interest rate.
E0
E30 E02
0
A lower E0 raises the expected
return on the dollar assets and
makes the interest parity hold.
Y0
Y
Y1
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Changes in macroeconomic equilibrium
Y∗
Changes in I, G, Y ∗ shift
the DD curve and affect
the equilbrium E0 and Y .
Goods
market
E0
E
G
I
Y
P
e
1
Changes in E1e , i∗ , P, M shift
FX
the AA curve and affect
market
the equilbrium E0 and Y .
i∗
i
Money
market
M
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Aggregate demand
given E 00 and I1
Shifting the DD
curve
Aggregate demand
given E 00 and I0
Suppose the investment
demand increases from I0 to I1.
The increase in the aggregate
demand raises the equilibrium
GDP at the same level of the
0
exchange rate, E0 .
An increase in the investment
demand shifts the DD curve
rightward.
Y0
E0
Y
Y1
D
E00
D′
D
D′
Y0
Y1
Y
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Shifting the DD curve
The same rightward shift of the DD curve happens if:
1. the government demand increases
2. the US GDP increases
3. the consumption demand increases for reasons
other than changes in exchange rates or GDP(*)
4. the net foreign demand increases for reasons other
than changes in exchange rates or GDP(*)
(*) Optional. Not included in Final.
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Re , i
Shifting the AA
curve
Given
L,
Y0
M
P
0
E0
Suppose the nominal money
stock increases from M0 to M1.
An increase in M raises
the equilibrium exchange rate
at the same level of GDP, Y0 .
E0
E02 E04
A A′
E40
E20
An increase in the nominal
money stock shift the AA curve
upward.
A′
A
Y0
Y
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Shifting the AA curve
The same upward shift of the AA curve happens if:
1. the price level falls
2. the demand for money increases for reasons other
than changes in interest rates or GDP(*)
3. the dollar interest rate rises
4. the future dollar appreciates
(*) Optional. Not included in Final.
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Changes in the macroeconomic equilibrium(1)
: shift of the DD curve
E0
If
• I increases
• G increases
• Y ∗increases
• C increases for some reason
• TB increases for some reason ,
Y
the yen/dollar exchange rate falls (= the yen appreciates)
and the GDP rises.
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Changes in the macroeconomic equilibrium(2)
: shift of the AA curve
E0
If
• P decreases
• L increases for some unknown
reason
• i∗ increases
• E1e increases,
Y
the yen/dollar exchange rate rises (= the yen depreciates)
and the GDP rises.
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Monetary and fiscal policy
External shocks that affect the macroeconomic equilibrium
Changes in I, G, TB, Y ∗ , P, M, L, E1e , i∗
It is possible that the governments and the central bank will use G and M
as policy instruments to cushion the external shocks to the economy.
Monetary policy: policy in which the central bank influences
the nominal stock of money, M.
Fiscal policy: policy in which the governments influence
the amount of government purchases, G .
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Countercyclical policy (1)
E0
Temporary fall in
investment demand
Fiscal policy could
reverse the fall in
aggregate demand
Monetary expansion
could depreciate the
yen and stimulate
aggregate demand
E0
②
E10
E0
E20
E10
E0
①
Y1 YN
Y
①
②
Y1 YN
Y
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Countercyclical policy (2)
E0
Fall in dollar
interest rate
appreciates the yen
Monetary policy
could increase
nominal stock to
lower yen interest
rate and
depreciate the yen
E0
①
E0
E30
Fiscal expansion
could stimulate
aggregate demand
①
E0
E30
E40
②
Y1 YN
Y
②
Y1 YN
Y
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1. Which curve is affected by which external shocks?
Changes in I, G, TB, Y ∗ , P, M, L, E1e , i∗
2. How are the DD and AA curve shifted by these shocks?
3. What are the effects on the macroeconomic equilibrium, Y, E0
and i ?
4. How could macroeconomic policies alleviate the effects
of those shocks to the economy? What is the difference
between fiscal and monetary policy?
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