The Portfolio Balance Approach to Exchange Rate Determination

Abstract

Monetary approaches to exchange rate determination, including the flexible price monetary model proposed by Frenkel (1976) and sticky price monetary model by Dornbusch (1976), assume that uncovered interest rate parity (UIRP) holds. This assumption implies that domestic and foreign assets are perfect substitutes, which the portfolio balance approach unequivocally deviates. The deviation arises from, among others, from different risk attitudes towards foreign financial assets in relation to domestic financial assets; or there exists a risk premium on holding foreign financial assets relative to holding domestic financial assets. Moreover and in contrast to the monetary models, foreign exchange rates are not expected to change, or exchange rate expectations are static with the portfolio balance approach. While purchasing power parity (PPP) holds continuously in the flexible price monetary model and PPP holds in the long-run in the sticky price monetary model of Dornbusch, there is no requirement for PPP to hold in the portfolio balance model. This implies that goods need not be perfect substitutes.