Exchange Rate Economics: Theories and Evidence

Currency substitution and portfolio balance models 169
uncertainty associated with portfolio holdings of domestic currency. Thus we may
rewrite (7.6) as:
= g[ṁ e , var ṁ e ], g 1 < 0, g 2 < 0,(7.7)
where ṁ e is the expected monetary expansion,and thus an expected increase in the
domestic money supply will cause investors to want to hold more foreign money. 6
A similar argument applies to an increase in the variance of ṁ e .
For simplicity,it is assumed that the conditions underlying the simple flex-price
monetary model considered in Chapter 4 hold here,namely PPP and UIP,and
additionally,the home country is assumed to be small. Using a log-linear version
of (7.5) it is straightforward to obtain (where we have normalised P ∗ to unity and
i ∗ to zero):
s = m − − α 1 y + α 2 ṡ e . (7.8)
Equation (7.8) is a monetary currency substitution reduced form. Notice that the
inclusion of implies that changes in currency preferences will have an independent,and
direct,effect on the exchange rate. Given the above assumptions about
ṡ e and (equation (7.7)),equation (7.8) may be pushed further. Thus,by assuming
equation (7.7) has the form:
= β 0 ṁ e + β 1 var ṁ; β 0 < 0, α 1 < 0,(7.9)
and on substituting for in (7.8),and using the fact that ṡ e =ṁ e ,we obtain
s = m − α 1 y + (α 2 − β 1 ) var ṁ e (7.10)
where,since β 0 < 0, α s − β 2 > 0. Thus,in addition to the traditional monetary
effects of m and y on the exchange rate equation (7.10) also demonstrates the
effect of CS. The coefficient of ṁ e is larger than it would be in the absence of CS
(i.e. α 2 − β 0 >α 2 ) because of the ability of agents to substitute between domestic
and foreign money,exacerbating pressure for a currency depreciation or appreciation.
This effect will be reinforced if the expected variability of monetary policy,
var ṁ e ,changes in tandem with the expected change in ṁ.
7.2.2 Wealth effects and two CS models
One of the criticisms of the MF model and its extensions,noted in Chapter 4,is
that positions of equilibrium are consistent with non-zero current account positions
and continual flows across foreign exchange markets. For example,following a
monetary expansion in the flexible exchange rate version of the MF model,the
small open economy runs a balance of payments surplus. This surplus must,over
time,be changing the country’s stock of assets: under a flexible exchange rate
domestic residents will be accumulating foreign assets (i.e. a capital account deficit
will be the counterpart of a current account surplus) and financial wealth must be