International Finance

Third edition

by Keith Pilbeam

Chapter 8 - The Portfolio Balance Model

Jump to Revision Questions for chapter 8

The monetary models of exchange rate determination make the crucial assumption that domestic and foreign bonds are perfect substitutes. This implies 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. As we saw, however, in Chapter 7 the portfolio balance model 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 return on the bond that is considered more risky to compensate for the additional risk it entails.

Allowing for domestic and foreign bonds to have different characteristics is potentially very important because operations that influence the exchange rate affect the composition of domestic and foreign bonds in agents’ portfolios in different ways. In this chapter we use the portfolio balance model to examine three operations that are commonly used to influence the exchange rate:

1) An open market operation (OMO) which is defined as an exchange of domestic money base for domestic bonds or vice-versa.
2) A foreign exchange operation (FXO) which is an exchange of domestic money for foreign bonds or vice-versa. Such foreign exchange market intervention affects the domestic money supply and is termed a non-sterilized intervention in the foreign exchange market.
3) A sterilized foreign exchange operation (SFXO) which is an exchange of domestic bonds for foreign bonds or vice versa leaving the domestic money base unchanged.

The interesting thing about an SFXO is that it represents the difference between an OMO and FXO. An expansionary FXO means that the authorities purchase foreign bonds with domestic money, which means that the public holds more money and less foreign bonds. If the authorities decide they wish to keep the money supply at its original level they can conduct a contractionary monetary policy by selling domestic bonds to the public so that the money held by the public returns to its original level. If they conduct such a sterilization operation, the net effect is that the public holds less foreign bonds and more domestic bonds with the money supply unchanged.

In the monetary models the only thing that matters for the exchange rate is money supply in relation to money demand, the source of money creation being unimportant. This means that in such models there is no difference in the exchange rate and interest rate effects of an FXO or OMO that change the money supply by like amounts. The reason being, that in the monetary models there is no distinction between domestic and foreign bonds. Within the context of the monetary models an SFXO will have no exchange rate or interest rate effects because it leaves money supply unchanged and is merely the exchange of domestic for foreign bonds which are perfect substitutes.

In this chapter we look at the portfolio balance model in more detail than was considered in Chapter 7. In particular, we examine the concept of a risk premium as crucial to the portfolio balance approach to exchange rate determination. We then look at different types of risks that may make domestic and foreign bonds imperfect substitutes and outline a simple version of the portfolio balance model and use this to examine the differing effects of OMOs, FXOs and SFXOs. We then look at the results in the light of their effects on the risk premium. Finally, we consider some of the dynamic features of the portfolio balance model.

Revision Questions
  1. Describe what is meant by a foreign exchange risk premium and what difference does it make if the pound is regarded as more risky that dollars? What are the factors that may generate a currency risk premium?
  2. Examine the possible impact of (a) a monetary expansion and (b) a fiscal expansion using the portfolio balance model on both the exchange rate and the domestic interest rate.
  3. Examine using a diagram the differing impacts of (a) an open market operation (b) a non sterilized foreign exchange operation and (c) a sterilized foreign exchange operation. All of which are designed to lead to a depreciation of the domestic currency on both the domestic interest rate and the exchange rate.
  4. In what sense is the portfolio balance model different than the monetary models and what different policy implications does it have?