Exchange Rate Economics: Theories and Evidence

178 Currency substitution and portfolio balance models
where α = σ/ī(1 + ī). Equation (7.34) indicates that relative currency demands
depend upon interest rates rate differentials and the responsiveness of relative
demands to interest differentials increases with the degree of CS,if an increase in
σ leads to an increase in α = σ/ī(1 + ī). Exploiting the UIP condition,may be
rewritten as:
s t = m t − m ∗ t + α(i t − i ∗ t ),(7.35)
which is a similar,two country,variant of (7.10),although here derived in a general
equilibrium setting. On the basis of (7.35),Canzoneri and Diba (1993) stress that
any conclusion about the relationship between currency substitution and α depends
upon an assumption about monetary policy. For example,an increase in σ could
conceivably induce new monetary policies that raise ī enough to lower α.
In this section we have introduced the concept of CS. Although the CS concept
is clearly an appealing one, 10 it would probably be more realistic to allow agents
to hold a portfolio of money and non-money assets. This is the topic to which we
now turn.
7.3 The portfolio balance approach to the
exchange rate
In the previous section some stock-flow interactions were considered in the context
of two CS models. Although,as was demonstrated,such models offer some
interesting exchange rate dynamics,they nevertheless concentrate on a narrow
range of assets,in particular,home and foreign money supplies. In this section
we expand the range of assets available to portfolio holders to include domestic
and foreign bonds and use the stock-flow framework to analyse the effects of
various asset market changes. The model outlined in this chapter may therefore
be viewed as an extension of the Mundell–Fleming–Dornbusch model,which
properly incorporates stock-flow interactions and also allows for the imperfect
substitutability of assets. The portfolio balance model has its origins and development
in research conducted by McKinnon and Oates (1966),Branson (1968,
1975) and McKinnon (1969). The portfolio model has been applied to the determination
of the exchange rate by, inter alia,Branson (1977),Allen and Kenen
(1978),Genberg and Kierzkowski (1979),Isard (1980) and Dornbusch and Fischer
(1980). The portfolio model presented here is a synthesis of the models contained in
these papers.
In contrast to the variants of the monetary model considered in previous
chapters,the domestic and foreign bonds in the portfolio balance approach are not
assumed to be perfect substitutes. There are in fact a number of factors (such
as differential tax risk,liquidity considerations,political risk,default risk and
exchange risk) which suggest that non-money assets issued in different countries
are unlikely to be viewed as perfect substitutions by investors. Thus,just as international
transactors are likely to hold a portfolio of currencies to minimise exchange
risk (i.e. currency substitution),risk-averse international investors will wish to hold