The portfolio balance approach extends the monetary model to specifically include other financial assets.
Therefore portfolio balance models are very general, and very complicated
In the simplest versions of the model individuals hold their wealth in the form of domestic money, a foreign bond, and a domestic bond.
The process of wealth accumulation links the short run with the long run
1. Domestic and foreign bonds are imperfect substitutes, and foreign bonds carry an additional risk premium.
Uncovered interest arbitrage is assumed to hold:
id = if + xa - RP, where
id and if are domestic and foreign interest rates,
xa is the expected appreciation of the foreign currency
RP is the risk premium.
2. The demand equations for each of the three assets are given by:
Money demand: L = f(id, if, xa, Yd, Pd, Wd)
Domestic bond demand: Bd = h(id, if, xa, Yd, Pd, Wd)
Foreign bond demand: eBf = j(id, if, xa, Yd, Pd, Wd)
Bolded variables have a positive relationship with the relevant asset demand
3. The domestic monetary authorities fix the supply of money.
The supply of bonds is also fixed.
4. The wealth of the domestic country is given by:
Wd= Ms + Bh + eB0,
where Ms is the money supply, Bh is the stock of domestic bonds actually held by domestic residents, eB0 is the stock of foreign bonds actually held by domestic residents
5. There is a foreign country equivalent of each of the equations.
Equilibrium in the model implies that all markets clear simultaneously.
This determines the equilibrium interest rate, as well as the exchange rate between currencies. Any rearrangement of the wealth holder’s portfolio will impact the exchange rate.
1. Open market sales of government securities by domestic authorities.
This reduces domestic money supplies, and increases the supply of domestic bonds. Excess demand for money. Domestic interest rates rise. Investors switch from foreign bonds to domestic bonds. The exchange rate will fall (domestic appreciation). Foreign interest rates will also rise, but not as much as domestic interest rates. From the uncovered interest arbitrage equation with risk, id - if = xa - RP, and assuming RP is constant, the interest differential leads to an expected appreciation of the foreign currency. (Under fixed exchange rates the B of P would improve).
2. An
increase in domestic real income leads to increased demand for money. This
leads to a decrease in the demand for foreign bonds, as domestic residents swap
bonds for money. The domestic currency appreciates. (In a fixed exchange rate
regime, the B of P improves).
3.
An increase in domestic bond supply. The government
deficit increases or firms issue new debt. The domestic interest rate rises to
clear the market for domestic bonds. This induces a capital inflow and an
appreciation of the domestic currency. The increase in domestic bonds also
increases domestic wealth. This increases demand for all assets. In theory a
strong increase in the demand for foreign bonds could lead to a net capital
outflow, and the depreciation of the domestic currency, but this seems
unlikely. Therefore we would expect an appreciation of the home currency, or a
B of P improvement.
4. An increase in the supply of foreign bonds. Increases the foreign interest rate, leading to capital outflows, and domestic currency depreciation (B of p deficit)
However, if the bond issue is accompanied by an increase in the risk premium there could be a capital inflow as capital takes flight from the risky bonds, leading to domestic currency appreciation, (or B of P surplus). Many of the portfolio balance models predictions are driven by changes in the risk premium.
Note that as in the monetary approach, B of P imbalances are self-correcting, or exchange rates only change during the adjustment process.