Assumptions of Portfolio Balance Approach

According to the Portfolio Balance Approach the economic agents have to choose from a portfolio of domestic and foreign assets. These assets, may they be in the form of bonds or money, have an expected return, which had arbitrage opportunity. This opportunity helps to determine exchange rates.

The portfolio Balance Approach is based on the following assumptions.

The Purchasing Power Parity, which is based on the law of one price, is not applicable here since goods are not assumed to be identical.

The size of the domestic country is so small that it cannot have any effect on the foreign rate of interest. Exchange rate is fixed.

Portfolio Balance Approach In Determining Exchange Rates

Three types of assets are available to the economic agents. One is cash that does not yield any interest but is useful for the purpose of purchasing products. Two s domestic Bonds (B) that yield an interest rate, i. Foreign Bonds yield an interest rate, i*. 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 to form of portfolio.

Now, let us come to the wealth of an individual. It is expressed as W = B + eB* + M,

Dividing both sides by the price level,

W/P = B/P + eB*/P + M/P,

We get the wealth in real terms

The portfolio balance approach determines the equilibrium exchange rate, domestic and international interest rate that would clear the domestic bond market, money market and the foreign bond market.

Money Market

Let us assumes that the dollar suffers 10% depreciation. This would increase the foreign asset value by 10%. This in turn causes an increase in the total wealth, which would lead to an expansion in the demand for all kinds asset, which would also include money.The wealth effect of this depreciation in currency would lead to a rise in the domestic interest rate. With all parameters fixed a rise currency depreciation is accompanied by a rise in the money market interest rate.

Domestic Bond Market

In the face of dollar depreciation, by say 10%, the demand of domestic bonds will be on a high. This would result in a low domestic interest rate.

Domestic and foreign bonds have different risk exposures although they may be a part of the same portfolio.

Foreign Bond Market

In response to 10% dollar depreciation the supply of foreign bonds increases. Due to the wealth effect the demand for foreign bonds also rises. Keeping all parameters fixed, depreciation in currency would lead to a fall in the domestic interest rate via the foreign bond market.

The portfolio balance approach gives the equilibriums interest rate, both domestic and foreign as well as the exchange rate that would clear all the three markets, domestic money and bond market and foreign bond market.