The Theory of the Financial Economy
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The essential message of Chapter 4 was that financial assets with different currency denominations are imperfect substitutes. This consideration justifies modelling the financial economy according to portfolio-balance principles. The literature on this subject is of recent vintage. While Fleming (1962) and Mundell (1963) are credited with having inspired the portfolio-balance approach, it was not until the early 1970s that economists adapted James Tobin’s well-known contribution to the theory of asset determination — developed for a closed economy — to an economy that desires to be a holder of net external claims (net external liabilities), that is an economy with a surplus (deficit) in its cumulative current account of the balance of payments.1 The exchange rate, in this framework, adjusts so as to ensure that asset supplies are willing held. Thus, by its very nature, this view emphasises the short run.
KeywordsExchange Rate Financial Economy Credit Market Excess Demand Money Market
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