Exchange Rate Determination: The Portfolio-Balance Approach

The portfolio-balance approach to exchange rate determination is part of the Asset Market Models and is largely attributed to economists after 1973 when the exchange rate became flexible (market determined). This article first introduces the setting of the model embedded in the portfolio balance approach that encompasses two assets (money and bonds), which deviates a little from the models and approaches used for the monetary approach to the balance of payment, the overshooting model, and from the associated market equilibria. The effects of monetary policy, of current account, and of wealth under the portfolio-balance approach are examined, here, theoretically and empirically. The current econometric results show that the exchange rate is determined by the foreign bonds, the domestic interest rate, and the foreign interest rate. JEL classification numbers: F31, F47, E52, E41, C52, E21, E43. Keywords: Foreign Exchange, Forecasting and Simulation, Monetary Policy, Demand for Money, Model Evaluation and Testing, Consumption and Saving, Interest Rates.