Revisiting the AA-DD model in Zero Lower Bound

MAO TAKONGMO, Charles Olivier (2019): Revisiting the AA-DD model in Zero Lower Bound.

Abstract

This paper proposes a simple model of a mechanism through which exchange rate can affect the link between output and government spending in zero lower bound (ZLB) periods. In our proposed model, the expected near-future interest rate is added as an endogenous variable. Unlike existing AA-DD models in ZLB, the nominal exchange rate is no longer constant. Our model predicts that the output effect of an increase in government spending in a ZLB period is deflected by an appreciation of the current exchange rate. The AA-DD model is taught in almost all economic departments. The model is also generally used by many central banks and governments. The existing AA-DD model can be misleading. Our new AA-DD model may help to update the existing model in ZLB periods. Our AA-DD model is also consistent with recent dynamic stochastic general equilibrium models in open economies in ZLB periods.

• Item Type: MPRA Paper
• Language: English
• Keywords: Zero lower bound; The exchange rate; Government Spending.
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

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