The portfolio approach to BOP and exchange rate determination

1
The portfolio approach to BOP and exchange rate
determination

• Concepts and exemplification

2
The concept

• The BOP and exchange rates are determined by the
  relative supply of and demand for money,
  domestic, and foreign income securities

3
The allocation of wealth

• Households, investors, and firms allocate wealth
  among domestic cash, domestic bonds and foreign
  bonds
• W Mb Bd Bf

4
Changes in the domestic money supply

• Assume the central bank purchases securities in
  the open market.
• The money supply would increases and the interest
  rate would decrease.
• Households and investors will switch from
  domestic to foreign bonds.
• The domestic currency would depreciate.

5
Changes in the domestic money supply (2)

• Assume the central bank sells securities in the
  open market.
• The money supply would decreases and the domestic
  interest rate would increase.
• Households and investors will switch from foreign
  to domestic bonds.
• The domestic currency would appreciate.

6
Changes in foreign interest rates

• A relative increase in the foreign interest rates
  would prompt households and investors to switch
  from domestic to foreign bonds.
• The domestic currency would, hence, depreciate.
• A relative decrease in the foreign interest rates
  would prompt households and investors to switch
  from foreign to domestic bonds.
• The domestic currency would, hence, appreciate.

7
What happens to the BOP?

• When households and investors switch from
  domestic to foreign bonds, a capital account
  deficit might result
• When households and investors switch from foreign
  to domestic bonds, a capital account surplus
  might result

8
Policy implications

• When central banks purchase foreign exchange
  reserves the demand for foreign currency deposits
  and bonds increases.
• On the other hand, sterilization involves the
  sale of domestic securities.
• Foreign exchange interventions amount to an
  exchange of domestic bonds for foreign bonds.
• The domestic currency would, hence, depreciate.

9
Policy implications

• According to the portfolio approach, foreign
  exchange interventions are somewhat effective.