Exchange Rate Economics: Theories and Evidence

182 Currency substitution and portfolio balance models
S
BB
MM
A
S 0
FF
i 0 i
0
Figure 7.5 Asset market equilibrium.
As the demand for money rises,for a given supply,i (the opportunity cost of
holding money) must rise to maintain money market equilibrium – hence the
positive MM curve in S–i space. The BB curve has a negative slope since the
increased demand for bonds,for a given supply,raises their price and results in
a lower rate of interest. The negative slope of the FF schedule may be explained
by a fall in i which increases the attractiveness of foreign assets leading to a rise
in S. Then BB is steeper than FF because domestic demand for domestic bonds
is more responsive than domestic demand for foreign assets to changes in the
domestic rate of interest (this follows from the assumed gross substitutability of
assets).
The three schedules in Figure 7.5 will shift in response to various asset disturbances.
For example,an increase in the money supply will shift the MM schedule
to the left since,for a given value of S,the interest rate must fall to restore portfolio
balance. An increase in the supply of bonds shifts the BB schedule to the right
since,for a given value of S,the interest rate on bonds must rise (price must fall)
for the supply to be willingly held. An increase in the foreign asset F will result in
the downward movement of FF since,for a given value of i,the maintenance of
portfolio balance requires an exchange rate appreciation.
Because of the wealth constraint (7.37),we know that only two of the three asset
equations are independent. Thus,if a given change restores equilibrium in two
markets,the third market must also be in equilibrium. In order to analyse various
shocks it is therefore legitimate to concentrate on only two schedules. In what
follows we concentrate either on the combination of BB and MM or on BB and
FF. Using the combination BB and FF we may illustrate that the portfolio system is
globally stable. Consider point A in Figure 7.5,a point which is above the BB–FF