Question

12 2 . 3. 4 15 16 Explicate the portfolio balance view of ER determination. (please explain in detail)

Answer 1

The portfolio balance approach model can be said as an extension of the monetary exchange rate model. It focuses on the impact of bonds. As per this approach, any changes within the economic condition of a nation can have a direct impact on the overall demand and supply for the bonds of domestic and foreign nature. This shift within the demand and supply for bonds will eventually going to influence the exchange rate between domestic as well as foreign economies. The main benefit of this approach as compared to other traditional approaches is that financial assets will adjust with a bit more pace to new conditions within the economy than tradeable goods.

The portfolio balance approach has certain assumptions, these are as follows:

• As per this approach, the PPP or Purchasing Power Parity does not hold
• Uncovered interest parity does not exist
• There is no change in exchange rate
• Under this approach, it is assumed that households have only three options for the purpose of investments, these are domestic bonds, foreign bonds, money.
• Narrow or low transaction cost