Short-Run Equilibrium for an Open Economy

Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
By assuming that output prices are temporarily fixed, we have derived two separate schedules
of exchange rate and output levels: the DD schedule, along which the output market is
in equilibrium, and the AA schedule, along which the asset markets are in equilibrium.
A short-run equilibrium for the economy as a whole must lie on both schedules because
such a point must bring about equilibrium simultaneously in the output and asset markets.
We can therefore find the economy’s short-run equilibrium by finding the intersection of
the DD and AA schedules. Once again, it is the assumption that domestic output prices are
temporarily fixed that makes this intersection a short-run equilibrium. The analysis in this
section continues to assume that the foreign interest rate , the foreign price level ,
and the expected future exchange rate Ee also are fixed.
R* P*
L R, Y Y E
R*
R* Ee
R* R*
Ee
436 PART THREE Exchange Rates and Open-Economy Macroeconomics
Figure 17-8 combines the DD and AA schedules to locate short-run equilibrium. The
intersection of DD and AA at point 1 is the only combination of exchange rate and output
consistent with both the equality of aggregate demand and aggregate supply and asset
market equilibrium. The short-run equilibrium levels of the exchange rate and output are
therefore and .
To convince yourself that the economy will indeed settle at point 1, imagine that the
economy is instead at a position like point 2 in Figure 17-9. At point 2, which lies above AA
and DD, both the output and asset markets are out of equilibrium. Because is so high relative
to AA, the rate at which is expected to fall in the future is also high relative to the
rate that would maintain interest parity. The high expected future appreciation rate of the
domestic currency implies that the expected domestic currency return on foreign deposits is
below that on domestic deposits, so there is an excess demand for the domestic currency in
E
E
E1 Y1
Exchange
rate, E
Output, Y
1
AA
E1
Y 1
DD
Figure 17-8
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.
E1
Y1
Exchange
rate, E
Output, Y
1
AA
DD
2
3
E 2
E 3
Figure 17-9
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.
CHAPTER 17 Output and the Exchange Rate in the Short Run 437
the foreign exchange market. The high level of at point 2 also makes domestic goods
cheap for foreign buyers (given the goods’ domestic currency prices), causing an excess
demand for output at that point.
The excess demand for domestic currency leads to an immediate fall in the exchange
rate from to . This appreciation equalizes the expected returns on domestic and
foreign deposits and places the economy at point 3 on the asset market equilibrium
curve AA. But since point 3 is above the DD schedule, there is still excess demand for
domestic output. As firms raise production to avoid depleting their inventories, the
economy travels along AA to point 1, where aggregate demand and supply are equal.
Because asset prices can jump immediately while changes in production plans take
some time, the asset markets remain in continual equilibrium even while output is
changing.
The exchange rate falls as the economy approaches point 1 along AA because rising
national output causes money demand to rise, pushing the interest rate steadily upward.
(The currency must appreciate steadily to lower the expected rate of future domestic currency
appreciation and maintain interest parity.) Once the economy has reached point 1 on
DD, aggregate demand equals output and producers no longer face involuntary inventory
depletion. The economy therefore settles at point 1, the only point at which the output and
asset markets clear.