Results

Using the AA-DD model, several important relationships between key economic variables are shown:

• Expansionary monetary policyAn increase in the money supply in a country. (↑M^S) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate systemAn exchange rate system in which the value of a country’s currency is determined by the supply and demand for one currency in exchange for another in a private market operated by major international banks. in the short run.
• Contractionary monetary policyA decrease in the money supply in a country. (↓M^S) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run.
• Expansionary fiscal policyAn increase in government spending or transfer payments and/or a decrease in tax revenues. (↑G, ↑TR, or ↓T) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policyA decrease in government spending or transfer payments and/or an increase in tax revenues. (↓G, ↓TR, or ↑T) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.
• In the long run, once inflation effects are included, expansionary monetary policy (↑M^S) in a full employment economy causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls.
• A sterilized foreign exchange interventionOccurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response.
• A central bank can influence the exchange rate with direct Forex interventions (buying or selling domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.
• A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and their effect on interest rates.
• Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.

Connections

The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In Chapter 23 "Policy Effects with Fixed Exchange Rates", we’ll revisit these same government policies in the context of a fixed exchange rate system.

It is important to recognize that these results are what “would” happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Despite this problem, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements not described in the model may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.