Portfolio Balance Approach


The Portfolio Balance approach is a modern theory based on the relationship between the relative price of bonds and exchange rates.


The Portfolio Balance Approach Explained

The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds. According to this approach, any change in the economic conditions of a country will have a direct impact on the demand and supply for the domestic and the foreign bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between the domestic and foreign economies.

The key advantage of the portfolio approach when compared to traditional approaches is that the financial assets tend to adjust considerably faster to news economic conditions than tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange rates.


The Assumptions of Portfolio Balance Approach

The portfolio balance approach is based on several assumptions:

1. The purchasing power parity (PPP) does not hold

2. The uncovered interest parity does not hold

3. The exchange rate is expected unchanged

4. Only three (3) assets are available for investment for each household: money, domestic bonds, and foreign bonds  

5. Bonds are not perfect substitutes

6. Assumes perfect capital mobility without capital controls and similar barriers to investment

7. Assumes narrow transaction costs and high completion in the money markets



Portfolio Balance Approach Key Points

  • Emphasizes on the importance of global financial markets (especially as concerns the bond markets)
  • Assumes the existence of arbitrage between two economies
  • Offers a realistic and simplistic analysis framework
  • The portfolio balance approach, based on empirical evidence, hasn’t proven an accurate predictor of exchange rates



More Theories: ► Purchasing Power Parity (PPP) | ► Interest Rate Approach | ► Monetary Approach | ► Balance of Payments Approach



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