The Portfolio Balance Model
The monetary models of exchange-rate determination examined in Chapter 7 made the crucial assumption that domestic and foreign bonds are perfect substitutes. This implied that the expected yields on domestic and foreign bonds are equalized. In effect, apart from their currency of denomination domestic and foreign bonds are regarded by international investors as the same. In this chapter we examine the portfolio balance model which is distinguished from the monetary models because it allows for the possibility that international investors may regard domestic and foreign bonds as having different characteristics other than their currency of denomination. In particular, they might for various reasons regard one of the bonds as being more risky than the other. This being the case they will generally require a higher expected rate of return on the bond that is considered more risky to compensate for the additional risk it entails.
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Selected Further Readings
- Branson, W. H. (1976) ‘Asset Markets and Relative Prices in Exchange Rate Determination’, Institute for International Economic Studies, Seminar Paper No. 66, Stockholm.Google Scholar
- Branson, W. H. (1984) ‘A Model of Exchange Rate Determination with Policy Reaction: Evidence from Monthly Data’, in P. Malgrange and P. A. Muet (eds), Contemporary Macroeconomic Modelling (Oxford: Basil Blackwell).Google Scholar
- Branson, W.H. and Henderson, D.W. (1985) ‘The Specification and Influence of Asset Markets’, in P. B. Kenen, R.W. Jones (eds) Handbook of International Economics (Amsterdam: North-Holland).Google Scholar
- Frankel, J. A. (1983) ‘Monetary and Portfolio Balance Models of Exchange Rate Determination’, in J. S. Bhandari and B. H. Putnam (eds), Economic Interdependence and Flexible Exchange Rate (Cambridge, Mass.: MIT Press).Google Scholar
- Girton, L. and Henderson, P. W. (1977) ‘Central Bank Operations in Foreign and Domestic Assets Undes Fixed and Flexible Exchange Rates’, in P. B. Clark, D. E. Logue and R. J. Sweeny, The Effects of Exchange Rate Adjustment (Washington: Government Printing Office).Google Scholar
- Isard, P. (1983) ‘An Accounting Framework and Some Issues for Modelling How Exchange Rates Respond to the News’, in J. A. Frenkel, Exchange Rates and International Macroeconomics (Chicago: University of Chicago Press).Google Scholar
- Kouri, P. J. K. (1983) ‘The Balance of Payments and the Foreign Exchange Market: A Dynamic Partial Equilibrium Model’, in J. S. Bhandari and B. H. Putnam, Economic Interdependence and Flexible Exchange Rates (Amsterdam: North-Holland).Google Scholar
- Lee, D. (1983) ‘Effects of Open Market Operations and Foreign Exchange Market Operations Under Flexible Exchange Rates’, in M. Darby and J. R. Lothian (eds), The International Transmission of Inflation (Chicago: University of Chicago Press).Google Scholar
- Obstfeld, M. (1980) ‘Imperfect Asset Substitutability and Monetary Policy Under Fixed Exchange Rates’, in M. Darby and J. R. Lothian (eds), The International Transmission of Inflation (Chicago: University of Chicago Press).Google Scholar
- Wihlborg, C. (1978) ‘Currency Risks in International Finance Markets’, Princeton Studies in International Finance, no. 44.Google Scholar