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The Portfolio Balance Approach to Exchange Rates. 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) - PowerPoint PPT Presentation
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The Portfolio Balance Approach The Portfolio Balance Approach to Exchange Ratesto Exchange Rates
AssumptionsAssumptions The home country is too small to influence The home country is too small to influence
foreign interest rates. Further, foreign foreign interest rates. Further, foreign citizens do not hold domestic bonds.citizens do not hold domestic bonds.
PPP does not hold (Goods are not perfect PPP does not hold (Goods are not perfect substitutes)substitutes)
UIP does not hold (Bonds are not perfect UIP does not hold (Bonds are not perfect substitutes)substitutes)
Exchange rate expectations are static (i.e. Exchange rate expectations are static (i.e. exchange rates are not expected to exchange rates are not expected to change)change)
Available AssetsAvailable AssetsCash 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
Three MarketsThree Markets
Foreign Bond Market
Money MarketDomestic Bond Market
All three assets are supplied by the government
Three MarketsThree Markets
Foreign Bond Market
Money MarketDomestic Bond Market
Households choose a combination of the three assets for their portfolios
WealthWealth An individual’s wealth (W) is the current An individual’s wealth (W) is the current
market value of currently held assetsmarket value of currently held assets
W = B + eB* + MP P P P
Face value of Foreign bonds Face value of Foreign bonds converted to $sconverted to $s
Dividing by the Price Level (P) converts wealth to “real” terms
General EquilibriumGeneral Equilibrium
Foreign Bond Market
Money MarketDomestic Bond Market
We need three prices (e, i , i*) to clear the three markets!!
The Domestic Money The Domestic Money MarketMarketCash is used to buy goods (transaction Cash is used to buy goods (transaction motive), but pays no interestmotive), but pays no interest
M P = L ( i, i*+ %e ,W/P,Y/P )
- - -- + + + + d
Real Money Demand
Higher interest rates lower money demand
Higher real wealth raises demand for all assets
Higher real income raises transaction motive for holding cash
The Domestic Money The Domestic Money MarketMarket
Cash is Supplied by the Cash is Supplied by the Federal ReserveFederal Reserve
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
The Domestic Money The Domestic Money MarketMarket
An increase in the domestic An increase in the domestic money supply lowers money supply lowers domestic interest ratesdomestic interest rates
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
The Domestic Money The Domestic Money MarketMarket
A decrease in foreign A decrease in foreign interest rates raises the interest rates raises the demand for cash – this demand for cash – this raises domestic interest raises domestic interest ratesrates
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
W = B + eB* + MP P P P
Face value of Foreign bonds Face value of Foreign bonds converted to $sconverted to $s
Suppose that the dollar depreciates (e increases) by 10%
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
The Domestic Money The Domestic Money MarketMarket
The wealth effect from a The wealth effect from a currency depreciation currency depreciation raises domestic interest raises domestic interest ratesrates
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
6%
Money Market EquilibriaMoney Market EquilibriaHolding everything else Holding everything else fixed, currency fixed, currency depreciations are depreciations are associated with rising associated with rising interest rates in the money interest rates in the money marketmarket
i
e
10%
5% 6%
The Domestic Bond The Domestic Bond MarketMarketHome and foreign bonds have different risk Home and foreign bonds have different risk characteristics and are both part of a diversified characteristics and are both part of a diversified portfolioportfolio
B P = B ( i, i*+ %e ,W/P,Y/P )
+ + -- + + - - d
Real Domestic Bond Demand
Higher domestic interest rates relative to foreign interest rates increases demand for US bonds
Higher real wealth raises demand for all assets
Higher real income raises transaction motive for holding cash rather than bonds
The Domestic Bond The Domestic Bond MarketMarket
Bonds are Supplied by the Treasury, Bonds are Supplied by the Treasury, but are bought/sold by the Fedbut are bought/sold by the Fed
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
The Domestic Bond The Domestic Bond MarketMarket
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
An open market sale of An open market sale of bonds would increase supply bonds would increase supply – this raises interest rates– this raises interest rates
The Domestic Bond The Domestic Bond MarketMarket
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
An increase in foreign An increase in foreign interest rates lowers interest rates lowers domestic bond demand – domestic bond demand – this raises domestic interest this raises domestic interest ratesrates
W = B + eB* + MP P P P
Face value of Foreign bonds Face value of Foreign bonds converted to $sconverted to $s
Suppose that the dollar depreciates (e increases) by 10%
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
The Domestic Bond The Domestic Bond MarketMarket
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
This increase in demand for This increase in demand for domestic bonds domestic domestic bonds domestic lowers domestic interest lowers domestic interest ratesrates
4%
Domestic Bond Market Domestic Bond Market EquilibriaEquilibria
Holding everything else Holding everything else fixed, currency fixed, currency depreciations are depreciations are associated with falling associated with falling interest rates in the interest rates in the domestic bond marketdomestic bond market
i
e
10%
4% 5%
The Foreign Bond MarketThe Foreign Bond MarketHome and foreign bonds have different risk Home and foreign bonds have different risk characteristics and are both part of a diversified characteristics and are both part of a diversified portfolioportfolio
eB* P = F ( i, i*+ %e ,W/P,Y/P )
- - ++ + + - - d
Real Foreign Bond Demand
Higher domestic interest rates relative to foreign interest rates increases demand for US bonds
Higher real wealth raises demand for all assets
Higher real income raises transaction motive for holding cash rather than bonds
The Foreign Bond MarketThe Foreign Bond Market
Foreign Bonds are Foreign Bonds are Supplied by foreign Supplied by foreign governments, but are governments, but are bought/sold by the Fedbought/sold by the Fed
F (i*+ %e ,W/P,Y/P )++ + + + +
i eB*P
S
PB*
5%
The Foreign Bond MarketThe Foreign Bond MarketAn increase in the supply An increase in the supply of foreign bonds lowers of foreign bonds lowers domestic interest ratesdomestic interest rates
F (i*+ %e ,W/P,Y/P )++ + + + +
i
PM
5%
eB*P
S
Note: This assumes that the foreign interest rate is unaffected
The Foreign Bond MarketThe Foreign Bond Market
An increase in foreign An increase in foreign interest rates raises the interest rates raises the demand for foreign bonds – demand for foreign bonds – this raises domestic interest this raises domestic interest ratesrates
F (i*+ %e ,W/P,Y/P )++ + + + +
i eB*P
S
PB*
5%
W = B + eB* + MP P P P
Face value of Foreign bonds Face value of Foreign bonds converted to $sconverted to $s
Suppose that the dollar depreciates (e increases) by 10%
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
The Foreign Bond MarketThe Foreign Bond Market
The wealth effect from a The wealth effect from a currency depreciation currency depreciation raises demand for foreign raises demand for foreign bondsbonds
F (i*+ %e ,W/P,Y/P )++ + + + +
i eB*P
S
PM
5%
3%
The currency depreciation The currency depreciation also raises the dollar valued also raises the dollar valued supply foreign bondssupply foreign bonds
Foreign Bond Market Foreign Bond Market EquilibriaEquilibria
Holding everything else Holding everything else fixed, currency fixed, currency depreciations are depreciations are associated with falling associated with falling domestic interest rates domestic interest rates through foreign bond through foreign bond marketsmarkets
i
e
10%
3% 5%
Its assumed that the effect of a currency depreciation on domestic interest rates is stronger in the foreign bond market!!
General EquilibriumGeneral Equilibrium
A General equilibrium is a A General equilibrium is a combination of i, i* and e combination of i, i* and e that clears all three that clears all three markets!markets!
i
e
i
e
Example: An Open Market Example: An Open Market PurchasePurchase
Suppose that the Federal Reserve Suppose that the Federal Reserve Purchases domestic bondsPurchases domestic bonds This transaction will increase the This transaction will increase the
supply of cash and decrease the supply of cash and decrease the supply of domestic assetssupply of domestic assets
The Domestic Money The Domestic Money MarketMarket
An increase in the domestic An increase in the domestic money supply lowers money supply lowers domestic interest ratesdomestic interest rates
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
The Domestic Bond The Domestic Bond MarketMarket
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
The decrease in the supply The decrease in the supply of US bonds also lowers of US bonds also lowers interest ratesinterest rates
General EquilibriumGeneral Equilibriumdomestic money markets domestic money markets and domestic bond markets and domestic bond markets react to changing react to changing supplies….initially, the supplies….initially, the foreign bond market is foreign bond market is unaffectedunaffected
i
e
i
eHowever, the drop in domestic interest rates creates a shift to foreign securities this causes the dollar to depreciate
A Change in Foreign Interest A Change in Foreign Interest RatesRates
Suppose that foreign Suppose that foreign interest rates increase.interest rates increase.
i
e
i
e
The Domestic Bond The Domestic Bond MarketMarket
B (i*+ %e ,W/P,Y/P )-- + + + +
i BP
S
PB
5%
The rise in foreign interest The rise in foreign interest rates lowers the demand for rates lowers the demand for US bonds – US interest rates US bonds – US interest rates should riseshould rise
The Foreign Bond MarketThe Foreign Bond Market
Higher interest rates raise Higher interest rates raise the demand for foreign the demand for foreign bonds – US interest rates bonds – US interest rates riserise
F (i*+ %e ,W/P,Y/P )++ + + + +
i eB*P
S
PM
5%
The Domestic Money The Domestic Money MarketMarket
An increase in foreign An increase in foreign interest rates lowers the interest rates lowers the demand for money - demand for money - domestic interest rates falldomestic interest rates fall
L (i*+ %e ,W/P,Y/P )-- + + + +
i MP
S
PM
5%
General EquilibriumGeneral Equilibrium
The general equilibrium The general equilibrium produces a rise in the produces a rise in the exchange rate (a exchange rate (a depreciation) and a rise in depreciation) and a rise in domestic interest ratesdomestic interest rates
i
e
i
e
The Bottom LineThe Bottom Line The portfolio balance framework picks The portfolio balance framework picks
up where the monetary model left off. up where the monetary model left off. With the elimination of PPP and UIP, With the elimination of PPP and UIP,
there is a need to add foreign assets there is a need to add foreign assets markets into the picture.markets into the picture.
The addition of a portfolio choice The addition of a portfolio choice problem (Domestic vs. Foreign Assets) problem (Domestic vs. Foreign Assets) complicates the dynamics of exchange complicates the dynamics of exchange ratesrates
