20.5 Shifting the AA Curve

The AA curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the asset market model. The exogenous variable changed is gross national product (GNP). The endogenous variable affected is the exchange rate. At all points along the AA curve, it is assumed that all other exogenous variables remain fixed at their original values.

The AA curve will shift if there is a change in any of the other exogenous variables. We illustrate how this works in Figure 20.6 "AA Curve Effects from a Decrease in the Money Supply", where we assume that the money supply in the economy falls from its initial level M^S1 to a lower level M^S2.

Figure 20.6 AA Curve Effects from a Decrease in the Money Supply

At the initial money supply (M^S1) and initial GNP level Y_$¹, real money demand intersects real money supply at point G, determining the interest rate i_$¹. This in turn determines the rate of return on U.S. assets, RoR_$¹, which intersects the foreign British RoR_£ at G in the upper diagram, determining the equilibrium exchange rate E_$/£¹. If the money supply and all other exogenous variables remain fixed, while GNP increases to Y_$², the equilibriums shift to points H in the lower and upper diagrams, determining exchange rate E_$/£². This exercise plots out the initial AA curve labeled AA|_MS1 in the lower diagram connecting points G and H. Note, AA|_MS1 is read as “the AA curve given that M^S = M^S1.”

Now, suppose the money supply M^S falls to M^S2. The reduction in M^S leads to a reduction in the real money supply, which, at GNP level Y_$¹, shifts the money market equilibrium to point I, determining a new interest rate, i_$³. In the Forex market, the rate of return rises to RoR_$³, which determines the equilibrium exchange rate E_$/£³. The equilibriums at points I corresponding to the combination (Y_$¹, E_$/£³) are transferred to point I on the lower diagram. This point lies on a new AA curve because a second exogenous variable, namely, M^S, has changed. If we maintain the money supply at M^S2 and change the GNP up to Y_$², the equilibrium will shift to point J (shown only on the lower diagram), plotting out a whole new AA curve. This AA curve is labeled A′A′|_MS2, which means “the AA curve given that M^S = M^S2.”

The effect of a decrease in the money supply is to shift the AA curve downward. Indeed, a change in any exogenous variable in the asset markets that reduces the equilibrium exchange rate, except a change in GNP, will cause the AA curve to shift down. Likewise, any change in an exogenous variable that causes an increase in the exchange rate will cause the AA curve to shift up. A change in GNP will not shift AA because its effect is accounted for by the AA curve itself. Note that curves or lines can shift only when a variable not plotted on the axis changes.

The following table presents a list of all variables that can shift the AA curve up and down. The up arrow indicates an increase in the variable, and a down arrow indicates a decrease.

Refer to Chapter 16 "Interest Rate Parity" and Chapter 18 "Interest Rate Determination" for a complete description of how and why each variable affects the exchange rate. For easy reference though, recall that M^S is the U.S. money supply, P_$ is the U.S. price level, i_£ is the foreign British interest rate, and E_$/£^e is the expected future exchange rate.