Question

The Portfolio Balance Model assumes a country has foreign denominated assets, but no foreign denominated liabilities. How do you think the implications would change if the country had foreign denominated liabilities, but no foreign denominated assets? What implication may this have for the effect of portfolio rebalancing on exchange rate movements for countries with positive and negative net international investment positions?

Answer 1

According to portfolio balance approach the economic agents have to choose from a Portfolio of domestic and foreign assets these assets may have been in the form of points of money and have unexpected return which have arbitrage opportunity this opportunity helps to determine the exchange rate. The model assumes the country has foreign denominated assets but no denominated liabilities in this case foreign have expected return and better opportunities but no liabilities now here we assume the country only Has Fallen denominated liabilities in this case country has to pay off the liabilities and since it is having no I said the scope of its earning hedging and arbitrage becomes zero . Portfolio balance assume that there are only two financial assets money and bonds money is the medium of exchange and page no interest on refers to all the Asset accept money and that refers to equity as well as debt the portfolio balance model revolves around the choice of whether to hold wealth as money or bond when the assumptions says that it only holds liabilities in that case the country does not have the scope of earning through its money and bonds it has to first pay of its liabilities and has less role in determination of exchange rate . Portfolio balance approach in determining exchange rates Three Types of assets are available in the economic agent 1. cash that does not get any interest but is useful for the purpose of purchasing product 2.domestic bonds that a yield an interest rate . 3. foreign bonds yield an interest rate the government provides all the three types of assets that are mentioned the household sector then makes a choice from these three types of Assets of the portfolio portfolio balance approach determine the equilibrium exchange rate domestic and international interest rates that would clear the domestic bond market and money market and market let us assume that the dollar supposed it was in this would increase the foreigner set value by 10 person this in turn causes an increase in total wealth which would lead to an expansion in the demand of all kinds of acid which would also include Mani the wealth effect of this depreciation in currency would lead to rise in the domestic interest rate with all the parameters fixed arise currency depreciation is accompanied by a rise in the money market interest rate interface of dollar depreciation by 10% the demand of domestic bonds will be on high this would result in a low domestic interest rate domestic and foreign bonds have different risk exposure although they have may be a part of same portfolio. Foreign bond market in response to 10% dollar depreciation the supply of foreign Wars increases due to wealth affect the demand of foreign bonds also Rises keeping all the parameters fix depreciation in the currency would lead to a fall in the domestic interest rate via the foreign bond market the portfolio balance gives the equilibrium interest rate for domestic and foreign as well as the exchange rate that would clear all the three markets. The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds according to this approach any change in the economic conditions of the country will have direct impact on the demand and supply for domestic and foreign bonds this shift in the demand and supply for bonds will in turn influence the exchange rate between the domestic and foreign economics the key advantage of the portfolio approach when compared to traditional approaches is that the financial assets tend to adjust considerable faster to new economic conditions then tradable goods nevertheless based on Imperial evidence the portfolio balance approach is not an accurate predictor of exchange rate. We will utilise the following assumptions which provide 1 simple version of the portfolio balance approach the availability of foreign bonds and lack of uncovered interest parity are essential ko purchasing power parity does not hold home and foreign goods are not perfect substitutes either again contrary to the monetary approach exchange rate exceptions statistics uncovered interest parity does not hold home and foreign bonds have different risk characteristics and both along with money apart of portfolio diversify to balance risk and expected return.