Question

The AA schedule shows combinations of output and exchange rate at which two asset
markets, namely the foreign exchange market and the money market are simultaneously in
short-run equilibrium.
a) Why does the AA schedule slope downwards?
b) Consider an increase in the domestic money supply. What is the effect on nominal
exchange rate? Has the output changed? What happens to the AA schedule?
c) What other factors can cause a rightward shift in the AA schedule?

Answer 1

a. AA schedule slopes downward when there is a rise in a particular local country's price level. As lower exchange rate is required to keep the forex and money market in equilibrium. The equilibrium exchange rate lowers as there is an appreciation in currency value. Higher local interest rates also increase the value of a currency.

b. Exchange rate increases (depreciate) as increase in money supply leads to lower interest rate, where the demand for the local currency falls with respect to other currency. Output stays constant. The AA schedule shifts upwards.

c. Increase in foreign currency's interest rate and rise in expected future exchange rate causes a rightward shift in the AA schedule. Basically whenever a local currency depreciates, eg of depreciating 1USD = 70 pounds, when pound which is the local currency depreciates it will be more than 70.