The Portfolio Balance Approach to Exchange Rates

1. The Portfolio Balance Approach to Exchange Rates

2. Assumptions • The home country is too small to influence foreign interest rates. Further, foreign citizens do not hold domestic bonds. • PPP does not hold (Goods are not perfect substitutes) • UIP does not hold (Bonds are not perfect substitutes) • Exchange rate expectations are static (i.e. exchange rates are not expected to change)

3. Available Assets Cash Pays no interest, but needed to buy goods Domestic Bonds (B) Pays interest rate (i) Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency

4. Three Markets All three assets are supplied by the government Domestic Bond Market Money Market Foreign Bond Market

5. Three Markets Households choose a combination of the three assets for their portfolios Domestic Bond Market Money Market Foreign Bond Market

6. Wealth • An individual’s wealth (W) is the current market value of currently held assets Face value of Foreign bonds converted to $s W = B + eB* + M P P P P Dividing by the Price Level (P) converts wealth to “real” terms

7. General Equilibrium We need three prices (e, i , i*) to clear the three markets!! Domestic Bond Market Money Market Foreign Bond Market

8. The Domestic Money Market Cash is used to buy goods (transaction motive), but pays no interest - - + + d M L ( i, i*+ %e ,W/P,Y/P ) = P Higher real income raises transaction motive for holding cash Higher interest rates lower money demand Real Money Demand Higher real wealth raises demand for all assets

9. The Domestic Money Market Cash is Supplied by the Federal Reserve S M i P - + + 5% L (i*+ %e ,W/P,Y/P ) M P

10. The Domestic Money Market An increase in the domestic money supply lowers domestic interest rates S M i P - + + 5% L (i*+ %e ,W/P,Y/P ) M P

11. The Domestic Money Market S A decrease in foreign interest rates raises the demand for cash – this raises domestic interest rates M i P - + + 5% L (i*+ %e ,W/P,Y/P ) M P

12. Suppose that the dollar depreciates (e increases) by 10% Face value of Foreign bonds converted to $s W = B + eB* + M P P P P A 10% depreciation of the dollar raises the value of foreign assets by 10% This 10% increase in wealth raises demand for all assets including money

13. The Domestic Money Market S The wealth effect from a currency depreciation raises domestic interest rates M i P 6% - + + 5% L (i*+ %e ,W/P,Y/P ) M P

14. Money Market Equilibria Holding everything else fixed, currency depreciations are associated with rising interest rates in the money market e 10% i 5% 6%

15. The Domestic Bond Market Home and foreign bonds have different risk characteristics and are both part of a diversified portfolio - + + - d B B ( i, i*+ %e ,W/P,Y/P ) = P Higher domestic interest rates relative to foreign interest rates increases demand for US bonds Higher real income raises transaction motive for holding cash rather than bonds Real Domestic Bond Demand Higher real wealth raises demand for all assets

16. The Domestic Bond Market - + + S B (i*+ %e ,W/P,Y/P ) B i P Bonds are Supplied by the Treasury, but are bought/sold by the Fed 5% B P

17. The Domestic Bond Market - + + S B (i*+ %e ,W/P,Y/P ) B i P An open market sale of bonds would increase supply – this raises interest rates 5% B P

18. The Domestic Bond Market - + + S B (i*+ %e ,W/P,Y/P ) B i P An increase in foreign interest rates lowers domestic bond demand – this raises domestic interest rates 5% B P

19. Suppose that the dollar depreciates (e increases) by 10% Face value of Foreign bonds converted to $s W = B + eB* + M P P P P A 10% depreciation of the dollar raises the value of foreign assets by 10% This 10% increase in wealth raises demand for all assets including domestic bonds

20. The Domestic Bond Market - + + S B (i*+ %e ,W/P,Y/P ) B i P This increase in demand for domestic bonds domestic lowers domestic interest rates 5% 4% B P

21. Domestic Bond Market Equilibria Holding everything else fixed, currency depreciations are associated with falling interest rates in the domestic bond market e 10% i 4% 5%

22. The Foreign Bond Market Home and foreign bonds have different risk characteristics and are both part of a diversified portfolio d - + + - eB* F ( i, i*+ %e ,W/P,Y/P ) = P Higher domestic interest rates relative to foreign interest rates increases demand for US bonds Higher real income raises transaction motive for holding cash rather than bonds Real Foreign Bond Demand Higher real wealth raises demand for all assets

23. The Foreign Bond Market Foreign Bonds are Supplied by foreign governments, but are bought/sold by the Fed S eB* i P + + + 5% F (i*+ %e ,W/P,Y/P ) B* P

24. The Foreign Bond Market An increase in the supply of foreign bonds lowers domestic interest rates S eB* i Note: This assumes that the foreign interest rate is unaffected P 5% + + + F (i*+ %e ,W/P,Y/P ) M P

25. The Foreign Bond Market S An increase in foreign interest rates raises the demand for foreign bonds – this raises domestic interest rates eB* i P + + + 5% F (i*+ %e ,W/P,Y/P ) B* P

26. Suppose that the dollar depreciates (e increases) by 10% Face value of Foreign bonds converted to $s W = B + eB* + M P P P P A 10% depreciation of the dollar raises the value of foreign assets by 10% This 10% increase in wealth raises demand for all assets including money

27. The Foreign Bond Market The currency depreciation also raises the dollar valued supply foreign bonds S eB* i P The wealth effect from a currency depreciation raises demand for foreign bonds 5% + + + F (i*+ %e ,W/P,Y/P ) 3% M P

28. Foreign Bond Market Equilibria Holding everything else fixed, currency depreciations are associated with falling domestic interest rates through foreign bond markets e 10% Its assumed that the effect of a currency depreciation on domestic interest rates is stronger in the foreign bond market!! i 3% 5%

29. General Equilibrium e A General equilibrium is a combination of i, i* and e that clears all three markets! e i i

30. Example: An Open Market Purchase • Suppose that the Federal Reserve Purchases domestic bonds • This transaction will increase the supply of cash and decrease the supply of domestic assets

31. The Domestic Money Market An increase in the domestic money supply lowers domestic interest rates S M i P - + + 5% L (i*+ %e ,W/P,Y/P ) M P

32. The Domestic Bond Market - + + B (i*+ %e ,W/P,Y/P ) S B i P The decrease in the supply of US bonds also lowers interest rates 5% B P

33. General Equilibrium domestic money markets and domestic bond markets react to changing supplies….initially, the foreign bond market is unaffected e e However, the drop in domestic interest rates creates a shift to foreign securities this causes the dollar to depreciate i i

34. A Change in Foreign Interest Rates e Suppose that foreign interest rates increase. e i i

35. The Domestic Bond Market - + + B (i*+ %e ,W/P,Y/P ) S B i P The rise in foreign interest rates lowers the demand for US bonds – US interest rates should rise 5% B P

36. The Foreign Bond Market S eB* i P Higher interest rates raise the demand for foreign bonds – US interest rates rise + + + F (i*+ %e ,W/P,Y/P ) 5% M P

37. The Domestic Money Market An increase in foreign interest rates lowers the demand for money - domestic interest rates fall S M i P 5% - + + L (i*+ %e ,W/P,Y/P ) M P

38. General Equilibrium e The general equilibrium produces a rise in the exchange rate (a depreciation) and a rise in domestic interest rates e i i

39. The Bottom Line • The portfolio balance framework picks up where the monetary model left off. • With the elimination of PPP and UIP, there is a need to add foreign assets markets into the picture. • The addition of a portfolio choice problem (Domestic vs. Foreign Assets) complicates the dynamics of exchange rates