Factors that Shift the AA Schedule

Five factors cause the AA schedule to shift: changes in the domestic money supply, M"; changes in the domestic price level, P; changes in the expected future exchange rate, EL; changes in the foreign interest rate, /?*; and shifts in the aggregate real money demand schedule.

1. A change in Ms. For a fixed level of output, an increase in Mv causes the domestic currency to depreciate in the foreign exchange market, all else equal (that is, E rises).

iutput and the Exchange Rate in Asset Market Equilibrium

Exchange rate, £

Foreign exchange market

Money , market

Exchange rate, £

Money , market

Domestic-currency return on foreign-currency deposits

Domestic interest rate, R

Real domestic money holdings

Domestic-currency return on foreign-currency deposits

Domestic interest rate, R

Output rises

Real money supply

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.

Since for each level of output the exchange rate E is higher after the rise in M\ the rise in Ms causes AA to shift upward. Similarly, a fall in Ms causes AA to shift downward.

2. A change in P. An increase in P reduces the real money supply and drives the interest rate upward. Other things (including Y) equal, this rise in the interest rate causes E to fall. The effect of a rise in P is therefore a downward shift of AA. A fall in P results in an upward shift of AA.

3. A change in El. Suppose participants in the foreign exchange market suddenly revise their expectations about the exchange rate's future value so that Ee rises. Such a giire 16-7 The A4 Schedule

The asset market equilibrium schedule AA slopes downward because a rise in output from Y1 to Y2, all else equal, causes a rise in the home interest rate and a domestic currency appreciation from £' to E2.

Exchange rate, E

Output, Y

change shifts the curve in the top part of Figure 16-6 (which measures the expected domestic currency return on foreign currency deposits) to the right. The rise in Ee therefore causes the domestic currency to depreciate, other things equal. Because the exchange rate producing equilibrium in the foreign exchange market is higher after a rise in E*, given output, AA shifts upward when a rise in the expected future exchange rate occurs. It shifts downward when the expected future exchange rate falls.

4. A change in R*. A rise in R* raises the expected return on foreign currency deposits and therefore shifts the downward-sloping schedule at the top of Figure 16-6 to the right. Given output, the domestic currency must depreciate to restore interest parity. A rise in R* therefore has the same effect on AA as a rise in Ee: It causes an upward shift. A fall in R* results in a downward shift of AA.

5. A change in real money demand. Suppose domestic residents decide they would prefer to hold lower real money balances at each output level and interest rate. (Such a change in asset-holding preferences is a reduction in money demand.) A reduction in money demand implies an inward shift of the aggregate real money demand function L(R, Y) for any fixed level of Yt and it thus results in a lower interest rate and a rise in E. A reduction in money demand therefore has the same effect as an increase in the money supply, in that it shifts AA upward. The opposite disturbance of an increase in money demand would shift AA downward.

Was this article helpful?

0 0

Post a comment