Goods, Money and Forex Market

Goods, Money and Forex Market













  • GOODS , MONEY AND FOREX MARKET

  • This article deals with the derivation and the mechanism of the AA-DD model. The AA-DD model shows an amalgamation of the three markets: the foreign exchange (Forex) market, the money market, and the goods and services market. The DD curve is the locus all those  exchange rate and GNP combinations that maintain equilibrium in the goods and services market keeping  fixed the values for all other exogenous variables. There are cases when DD curve can shift rightward and leftward. The DD curve will shift rightward whenever government demand (G), investment demand (I), transfer payments (TR), or foreign prices (P£) increase or when taxes (T) or domestic prices (P$) decrease. Changes in the reverse direction i.e. whenever these exogenous variables increase they cause a leftward shift. The AA curve depicts those set of exchange rate and GNP combinations that maintain equilibrium in the asset markets, given fixed values for all other exogenous variables. At the intersection of AA and DD curve we get an equilibrium in the economy.

  • images (23)

  • The DD curve expresses the relationship between changes in one exogenous variable and one endogenous variable within the goods and services (G&S) market model. The exogenous variable here is the exchange rate. The endogenous variable that will be affected is the gross national product (GNP). At all points along the DD curve shown, it is assumed that all the remaining exogenous variables will remain fixed at their original values. The DD curve will shift when any of the other exogenous variables will change. Like if there is a lower investment demand in the economy. Now the effect of a fall in investment demand will be to lower aggregate demand and shift the DD curve to the left. This means that a change in any exogenous variable that reduces aggregate demand, barring the exchange rate, will cause the DD curve to shift to the left. Similarly any change in an exogenous variable that leads to an increase in aggregate demand will cause the DD curve to shift right. An exchange rate change will never shift DD because its effect is inbuilt in the DD curve itself. This will cause a movement along the DD curve.

  • The AA curve expresses the relationship between changes in one exogenous variable and one endogenous variable within the asset market model. This is the main difference between AA and DD curve. The exogenous variable here is the GNP. The endogenous variable that will be affected is the exchange rate. At all points along the AA curve shown, it is assumed that all the remaining exogenous variables will remain fixed at their original values. The AA curve will shift when any of the other exogenous variables will change. Suppose we consider the change in money supply in economy. Now the effect of a fall in money supply will be to  shift the AA curve to the left. This means that a change in any exogenous variable that reduces equilibrium exchange rate, barring the GNP, will cause the AA curve to shift to the left. Similarly any change in an exogenous variable that leads to an increase in money supply demand will cause the AA curve to shift right. An GNP change will never shift AA curve because its effect is inbuilt in the AA curve itself. This will cause a movement along the AA curve.

  • Now when both the G&S market and the asset markets are operating together, equilibrium in both markets can happen only when the DD curve meets the AA curve. This is shown at the point of intersection say F where we get super equilibrium, where  GNP and exchange rate are in equilibrium. Also it is important to see that at point F, the three markets—that is, the G&S market, the money market, and the foreign exchange market—are in equilibrium together. Because of this, point F is no more a simple old equilibrium; rather it is a superequilibrium .The superequilibrium can be defined as the point where we expect apt responses by firms, households, and investors to affect the exchange rate and GNP level, assuming the exogenous variables remain fixed at their original levels and assuming sufficient time is allowed for adjustment to the equilibrium to take place.

  • Lastly we consider some adjustment mechanism related to superequilibrium. When investment demand decreases, aggregate demand will surely fall short of aggregate supply, causing to an increase in inventories. Firms will respond by reducing supply, and GNP will  fall as a result. Initially, there will be no change in the exchange rate. Graphically, this is shown by a leftward shift from the initial equilibrium. Adjustment to changes aggregate demand will take place over the period of time. When GNP will fall, it will cause a decrease in domestic interest rates. With lower interest rates, the rate of return on domestic assets will fall below the international asses and international investors shift funds abroad, leading to a depreciation of domestic currency. Continued  reductions in GNP caused by excess aggregate demand will result in continuing decreases in interest rates and rates of return, repeating the whole  process above until the new equilibrium is reached in the economy again.

  • For further assistance in economics homework help or for other subject speak visit our assignment help site.










 


Comments