Exchange Rate Economics: Theories and Evidence

7 Currencysubstitution models
and the portfolio balance
approach to the exchange rate
7.1 Introduction
In this chapter we move away from the monetary class of model,where non-money
assets such as bonds are perfect substitutes,to the portfolio balance class of model
in which non-money assets are imperfectly substitutable. Before considering this
class of model,however,we first of all consider some currency substitution (CS)
models. Although such models have much in common with the monetary class
of models considered in the last three chapters,they also provide a nice link with
the portfolio balance models because they emphasise the importance of risk and
diversification,introduce a role for wealth effects into an exchange rate relationship
and also highlight the key interaction between current account adjustment,the
evolution of net foreign assets and wealth effects. As we shall see,such interactions
are also at the heart of some of the models of real exchange rate determination,
considered in Chapter 7 and the new open economy macreoeconomic models of
Chapters 9 and 10.
7.2 Currencysubstitution models
The monetary models considered in the last three chapters constrained home and
foreign residents to hold only their own monetary stock – there was no allowance
for the phenomenon of CS, 1 in which residents are allowed to hold money issued
in both the home and foreign country (or ‘monies’ in a multi-country setting). 2
However,in a regime of floating exchange rates,multinational corporations,
involved in international trade and investment,and speculators (such as commercial
banks) have an incentive to hold a basket of currencies in order to minimise
the risk of revaluation effects of potential exchange rate changes on their wealth 3
(i.e. economic agents will, ceteris paribus,shift their currency balances away from
dollars if they expect the dollar to depreciate). Thus,much as in traditional portfolio
balance theory,considered below,foreign exchange market participants have
an incentive to hold a basket of currencies,the proportions of the various currencies
in the portfolio varying with the risk and expected rates of return of the
specific currencies. The ability of foreign exchange market participants to substitute
between different currencies has been made possible due to the lifting of