Models of exchange rate determination jeffrey frankel. The theory of exchange rate determination was introduced in the middle of the last century. The applicability of the portfolio balance model of exchange. Theoretical framework the portfolio balance model can be specified following the assumptions by krueger 1983. We will use a multivariate cointegration technique to test for the existence of a longrun relationship supporting the monetary equation. In order to address these two issues, the analysis develops a portfolio balance model of exchange rate determination incorporating the role of central bank foreign exchange market intervention behavior. Determination of exchange rates mba knowledge base. Asset market approach to exchange rate determination. Portfolio balance approach in determining exchange rates.
The economics of foreign exchange and global finance. Assumptions of portfolio balance approach economy watch. A portfolio balance model of exchange rates in my last post, i explained how i like to think about the relationship between exchange rates and international balances. The portfoliobalance or assetmarket approach to exchangerate determination proposes that the exchange rate, as the domestic price of foreign currency, is. The model is not realistic enough to fully describe the dynamics of inflation. The applicability of the portfolio balance model of exchange rate. An empirical study of portfoliobalance and information. Models and strategies for exchange rate forecasting mcgrawhill library of investment and finance on free shipping on qualified orders. One is cash that does not yield any interest but is useful for the purpose of purchasing products.
Determinants of the south african exchange rate, south african journal of economics, 75, no. Tests of monetary and portfolio balance models of exchange rate. Firstly, this theory attempts to determine the rate of exchange through the forces of demand and supply and thus brings exchange rate determination in purview of the general theory of value. The model consists of seven equations where each endogenous variable is expressed as a function of. That ap proach was one of the most actively pursued lines of research during the 1970s revival of exchange rate theory and includes papers by branson, halttunen, and masson 1977, branson and henderson 1985, dornbusch. Recall that in chapter i, we emphasized that exchange rates are just prices that are determined by supply and demand considerations. The monetary model of exchange rate determination 59 better treatment. Moreover, the asset demand functions used in the early portfolio balance literature were not based explicitly on micro foundations. The asset approach emphasizes the financial asset market. In the same spirit of taking stock, i was asked in the present paper to present some econo metric tests of competing monetary and portfolio balance models of ex change rate determination. Pdf this paper studies the relevance of the assetmarket model of exchangerate determination theory for the korean won u.
The elasticity approach focuses on the domestic goods market and the foreign goods market, while the absorption approach focuses on the expenditures of economy as a whole. A portfolio balance model of exchange rates blogger. Asset approach to exchange rate foreign exchange economics. Two s domestic bonds b that yield an interest rate, i. The portfolio balance approach to exchange rate determination. Monetary and portfolio balance models of nominal exchange rates are described and evaluated. Thus the portfolio balance model is an asset market model of exchange rate. The portfolio balance model is a short term one, restricted to periods of less than one year where the exchange rate is viewed as. Macro approaches to foreign exchange determination by menzie d. My model predicts that a decrease in the supply of nominal bonds can lead to lower inflation.
Economic interdependence and flexible exchange rates. This is known as the asset approach or portfolio balance approach which explains the realworld events. In this context, different version of cushmans model 2007 using monthly bilateral data of turkey and u. A portfoliobalance model of inflation and yield curve. Three types of assets are available to the economic agents. The portfolio balance model is a second approach to modelling exchange rates. Testing a model by applying bilateral data of turkey and united states.
But as a result of economic articulation of turkey to the global world, global economic and financial headwinds. Most widely accepted theory according to ppp theory, when exchange rates are of a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations. The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds. Portfolio balance approach, exchange rate, money supply, bonds, balance of payments. Portfolio balance approach to exchange rate determination. In the following, we explain three models of exchange rate determination, namely, the purchasing power parityppp, the monetary model and the portfolio balance theory. Masson bank canada, ottawa, ontario kaa og9, canada received april 1980, revised version received march 1981 the conditions for stability of a portfolio balance model of exchange rate determination with art endogenous current account are. Exchange ratedetermination prepared by mariya jasmine m y 2. Northholland publishing company dynamic stability of portfolio balance models of the exchange rate paul r. Pdf portfolio balance approach to exchange rate determination. Because the theory is by now well known, we go through it as quickly as possible. We find that the portfolio balance model produces better forecasts than the randomwalk model when the structural model is well specified. Since that time many models and their modifications have been developed.
In his model, domestic money is the only available asset, there are no other. Keywords exchange rate interest rate monetary policy money supply domestic currency. A chapter in exchange rate theory and practice, 1984, pp 239260 from national bureau of economic research, inc. However monetary and portfolio balance considerations can explain the observed variability of the deutsche mark visavis other ems currencies. Jun 07, 2017 portfolio balance approach to bop adjustment and exchange rate determination or asset market approach since the mid 1970s after monetary approach 3. Monetary approach outflow of money if ms exceeds md under fixed exchange rates inflow of money if md exceeds ms under fixed exchange rates 4. According to this approach, any change in the economic conditions of a country will have a direct impact on the demand and supply for the domestic and the foreign bond. Exchange rate theory and practice, pages 239260, national bureau of economic research, inc. The key point was that current flows do not matter much in themselves. Reprinted with 1987 addendum in frankel, on exchange rates, mit press, cambridge,1993. It is because exchange rate plays fundamental role in any economy. Monetary and portfoliobalance models of exchange rate determination.
Previous studies have identified several factors that influence exchange rate levels. The development of a model capable of explaining exchange rate determination requires the identification of factors that affect exchange rate levels. View references in econpapers view complete reference list from citec citations. The applicability of the portfolio balance model of. Tests of monetary and portfolio balance models of exchange rate determination.
Exchange rate fluctuations and international portfolio. It first uses several news items about macroeconomic events. An empirical study of portfoliobalance and information e. Turkish economy started to be liberated in the beginning of 1980s and gradually to be a part of global economic and financial system. Tests of monetary and portfolio balance models of exchange rate determination, in exchange rate theory and practice, edited by j. The balance of payments theory of rate of exchange has certain significant merits. Domestic currency will depreciate suppose the forex market is in equilibrium or at interest rate parity, then the positive interest differential in favour of the foreign portfolio balance model and exchange rates asset market approach. This theory places a much greater emphasis on the role of the exchange rate as one of many prices in the global market for financial assets.
Seccions 4 and 5 examine the evidence relating to various formulations of those models, as well. Lecture notes 10 portfolio balance models of exchange rate. Chapter iv structural models of exchange rate determination in this chapter we will attempt to explain the behavior of exchange rates by analyzing the behavior of supply and demand in the foreign exchange rate market. Monetary and portfolio balance models of exchange rate determination, economic interdependence and flexible exchange rates, edited by j. The idea is that agents have a portfolio choice decision between domestic and foreign assets. Speculators in foreign exchange market would like to know the direction of exchange rate movement aforehand to make profit. Testing a model by applying bilateral data of turkey and united states article pdf available july 2018 with 1,348 reads how we.
The portfolio balance approach is a modern theory based on the relationship between the relative price of bonds and exchange rates. Moreover and in con trast to the monetary models, foreign exchange rates are not expected to change, or exchange rate expectations are static with the portfolio. Exchange rate plays vital role in an economy and thus has gained much attention in the literature. In common with the monetary approach, portfolio balance models of exible exchange rates focus on the role of asset stocks. The results show that monetary and portfolio balance considerations cannot explain the observed variability in the exchange rate of the deutsche mark visavis the u. The portfolio balance framework is a model that relates excess demands for stocks of outside assets to the expected yields on these assets. The relationship between exchange rates and stock prices. Foreign exchange popularly referred to as forex the conversion of one countrys currency into that of another. Finally, portfolio balance models, as well as the earlier monetary models of exchange rate determination, performed disappointingly not only. Real exchange rates, trade balance and capital flows in africa, journal of economics and business, elsevier, vol. Another asset model, the portfolio balance model, extends the analysis to consider a wider range of financial assets. Development of theories concerning determinants of exchange rate have been progressive with the portfolio balance model being the most intuitive addressing the criticisms of forerunner theories. Otapo, toyin waliu department of banking and finance adekunle ajasin university akungba akoko abstract.
Theories of exchange rate determination international economics. Lecture notes 10 portfolio balance models of exchange rate determination when economists speak of the portfolio balance approach, they are referring to a diverse set of models. The exchange rate, the balance of payments and monetary and fiscal policy under a regime of controlled floating, scandinavian journal of economics, wiley blackwell, vol. A portfolio theory of international capital flows, the institute for international. This is why a new approach to exchange rate determination has been devised. Finally, portfolio balance models, as well as the earlier monetary models of exchange rate determination, performed disappointingly not only in. I the stochastic behavior of exchange rates and related variables experience with floating exchange rates between the united states dollar and other major currencies the british pound, the german mark, the french. The portfolio balance model is described in some detail in other textbooks such as pilbeam 1998, hallwood and macdonald 2000 and in branson and henderson 1985. However, results indicate the potential for portfolio balance effects of quantitative easing that are contrary to the common wisdom of policymakers. Tests of monetary and portfolio balance models of exchange rate determination, nber chapters, in.
Monetary and portfoliobalance models of exchange rate. Theories of exchange rate determination international. This theory places a much greater emphasis on the role of the exchange rate as one. This paper will trace the development of the monetary approach to exchange rate determination and examine how woodbury school of business, utah valley university, 800 west university parkway.
However, neither approach models the monetary sector explicitly. This study analyses the performance of reducedform exchange rate models of the portfolio balance approach applied to the singapore database. Dynamic stability of portfolio balance models of the. Marston, university of chicago press, chicago, 1984.
The portfolio balance model is a short term\ud one, restricted to periods of less than one year where the exchange rate is viewed as\ud an asset price influenced by changes in the demand and supply of domestic money,\ud domestic and foreign currency denominated financial assets. View citations in econpapers 30 track citations by rss feed. Secondly, this theory relates the rate of exchange to the bop situation. In this framework, in terest rates and exchange rates are determined simultaneously as wealthholders adjust their. With its focus on a broad menu of assets, this approach provides richer insights than the monetary approach into the forces influencing exchange rates. A test of monetary and portfolio balance models of. Objectives of the study in his important contribution, dombusch 1976 presents a monetary approach model to exchange rate determination in the short run. This pdf is a selection from an outofprint volume from the national bureau of economic. Monetary and portfolio approaches this is an asset pricing view of the exchange rate. Moreover and in contrast to the monetary models, foreign exchange rates are not expected to change, or exchange rate expectations are static with the portfolio balance approach. Chapter 6 spot exchange rate determination chapter overview this chapter examines the economic determinants of the spot exchange rate.
Over the past 35 years, the monetary approach to understanding exchange rates has become the dominant model of exchange rate determination diamandis and kouretas. Combination of the reducedform models of monetary and balance of pay ments equilibrium yields in sec. 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. The purpose of the study is to test the portfolio balance approach which proposes that money. Introduction determination and forecasting of exchange rate has been widely investigated by academics and practitioners through different models and theories. Tests of monetary and portfolio balance models of exchange.
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