The DD-AA Model
The DD-AA model is an interpretation of three market models, that is, the Foreign exchange, the money, and the product markets. This model consists of two curves, each representing particular market variables, and conditions. The AA curve runs from top-left side of the graph to bottom-right representing an asset market balancing trend. The DD curve runs from top-right to bottom-left to represent the equilibrium effect on household products. Therefore, the DD curve describes the equilibrium level achieved due to changes in the gross national product (GNP), taking into account exchange rate variations at any given time. The assumption that firms react to excess demand by supplying more products lead to shifts in GNP, which rather cause economic equilibrium on product demand. The AA curve signifies an equilibrium exchange rate attained for every existent GNP level. The AA curve equilibrium is influenced by the forex return rate, which influence investors’ decision on either buying or selling the foreign currency based on economic conditions.
The DD curve explains the correlation between the exchange rates and the gross national product taking into account the fixed nature of other factors. As such, the DD curve is a derivative of the product simulation consisting of various elements, including investment and government demand as well as resulting price levels. As a result, an upward shift would be caused by an increase in demand, more state expenditures, higher foreign prices or otherwise a reduction in taxes. The AA curve tends to shift upwards each time money supply increases, and again when the market experience a rise in foreign rate of interest or expected exchange rate. The intersecting AA-DD curves draws an economic equilibrium between asset and product markets.
It is apparent that the AA curve slopes downward because the expected short run future exchange rate is fixed, besides the market experiencing constant domestic and foreign interest rates. As such, if the exchange rate rises, there would be a reduction in the gross domestic product. The DD curve slopes upwards on account that a rise in the exchange rate would lead to more exports, which amounts to increased total demand. This leads to a significant shift from imports to enhanced domestic production that give rise to a positive correlation coefficient. The slope of the curve represents how speedy adjustments occur in goods and asset markets.
The main factors shifting the curves include monetary resource, which when reduced induces the AA curve shift to the left. Other factors include the American price level, tax revenues, the expected rate of exchange, government transfer payments, as well as the British rate of interest. The intersecting of AA-DD curves develops a super-equilibrium position that shows the existence of simultaneous equilibrium amidst the product, the exchange, as well as the domestic money markets. At this point, households, investors, as well as firms exhibit several behavioral changes adjusting to the status.
Monetary and fiscal policies greatly influence economic variables that determine the structure of the AA-DD account, and affected by changes in global transactions and financial flows. For instance, if there were an increase in money supply, there would be a resultant interest rate drop. As such, the domestic currency depreciates, which leads to local products being cheaper and as a result increasing aggregate demand. A decrease in taxes would amount to increased product demand due to better business conditions, thus shifting DD downwards.