Portfolio Balance Models of Exchange Rates

Summary

In the short-run the exchange rate is governed by asset market conditions and determined (alongside the interest rate) by the interaction of asset demands and asset stocks.

Assumptions

  • Open economy
  • Four assets in the Branson Model - domestic money, foreign money, domestic securities, foreign securities. 
  • Neither money bears interest and the terms of money exchange is the exchange rate. Securities cannot be directly traded. 
  • No currency substitution allowed. 

Model/Theory

Have Market equilibrium when four conditions hold: 

  1. W=M+B+eF
  2. M=m(i,i*,pi)W
  3. B=b(i,i*,pi)W
  4. ef=f(i,i*,pi)W

Where W = domestic net wealth, M is domestic currency, B = domestic securities e = home price of foreign exchange, pi=expected depreciation of domestic currency

Given i* ,pi ,M , B and F determine e and i which can then be plotted for the MM, BB and FF markets

FF curve is flatter than the BB curve because domestic demand for domestic bonds is more responsive than domestic demand for foreign assets to change in the domestic interest rate. 

Predictions

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If the exchange rate determined on the asset markets is not consistent with the balance of trade and import/export flows then a current account balance will be matched with a corresponding capital account imbalance. 

E.g. if stock of foreign assets increases (perhaps because of trade surplus) there is an increase in wealth, but people will wish to balance their portfolios and thus the MM and BB curves shift down as people sell the foreign asset to buy domestically. 

  1. Exchange rate adjusts to long-run equilibrium determined by PPP as predicted by flow theory of exchange rates.
  2. In the short-run the exchange rate is governed by asset market conditions and is determined along with the rate of interest by asset models of exchange.
  3. Government policy affects asset stocks (money, bonds) and in turn affects the exchange rate and the interest rate and thus is an important channel for monetary (and fiscal policy) to be transmitted to the domestic economy.

Evidence

Short-run importancce of asset market conditions, the role of asset stocks in affecting exchange rates and the interest rate and the importance of expectations of future exchange rates seem indisputable. 

The long-role of PPP is the more controversial.

Evaluation

  • With era of floating exchange rates after 1971 economists had two main tools. Neither however was a good basis for explaining exchange rate movements. 
    1. Flow theory of exchange rates --> demand for foreign exchange to buy imports = supply of foreign exchange from the sale of exports
      • Only a small and rapidly shrinking part of foreign exchange transactions was around traded goods. 
      • Even if add capital inflows & outflows can't explain how large these flows are or how long they last.
    2. Purchasing power parity.
      • Only useful in the long-run
  • Expectations about exchange rates affect the exchange rate just like with any other asset class.