The portfolio approach to BOP and exchange rate determination

Concepts and exemplification

The concept

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

foreign income securities

The allocation of wealth

Households, investors, and firms allocate wealth among domestic cash, domestic bonds and foreign bonds:

W = Mb + Bd + Bf

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.

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.

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.

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

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.

Policy implications

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