Question

Analyze the Portfolio Balance View.

Answer 1

Portfolio balance method is one of the method to asset model approach, the other one is the monetary approach. Portfolio balance method is also said to be the extension to the monetary approach to model asset price. According to this method any change in the economic environment will have direct impact on the demand and supply of domestic, non-domestic bonds and this will influence the exchnage rate.  Monetary approch follows the perfect capital substituteability approch where as portfolio balance approach focuses on Imperfect capital subsituteability between domestic bonds and non-domestic bonds.

The major advantage of this method when compared with the other is that financial assets tend to adjust faster to economic news than commodities. There is also simplicity in the assumption behind this approach. It assumes that only three assets are available for household investment Money, domestic bonds, foreign bonds.Purchasing power parity and Interest rate parity does not hold. Bonds are not perfec substitute. Despite all the feature, it does have some features that does not make it applicable to all economic environment.