Exchange Rate Economics: Theories and Evidence

184 Currency substitution and portfolio balance models
S
YT
C T
B
M
F
S 0 F
i 0 i
M
B
C T
Y T
Y T 0, C T
0
0
Figure 7.7 Asset and goods market equilibrium in the portfolio balance model.
In Figure 7.7 we combine Figures 7.5 and 7.6 to give a representation of joint
asset and goods market equilibrium as i 0 , S 0 , Y0 T , C 0 T . Consider now a number
of shocks which upset the system’s initial equilibrium. In particular,we consider
an open market swap of money for bonds,an increase in the supply of bonds and
an asset preference shift between home and foreign bonds.
7.4 Open market purchase of bonds: monetarypolicy
7.4.1 Impact period
We first consider the impact effect on asset markets of an open market purchase
of bonds for money. An open market purchase of bonds for money by the central
bank,in the impact period,will shift the BB and MM curves leftwards to BB ′ ,
MM ′ in Figure 7.8. At the initial equilibrium,X,the open market purchase of
bonds leaves asset holders with an excess supply of money and excess demand for
bonds. In their attempts to buy bonds,investors will push the domestic interest
rate down and this,in turn,will lead to an increased demand for foreign bonds
which will push the exchange rate upwards until the excess demand for foreign
bonds is eliminated. If it is assumed that the domestic interest elasticity of demand
for money is less than the domestic interest elasticity of the demand for foreign
bonds,then the percentage change in the demand for foreign bonds will be greater
than the percentage increase in the money stock. Given that there is a one-to-one
relationship between S and F ,this implies that the exchange rate change will be
larger than the money supply change: the exchange rate overshoots. The impact
period equilibrium is given at point Y.