The Portfolio Balance Model

Abstract

The monetary models of exchange-rate determination examined in Chapter 7 made the crucial assumption that domestic and foreign bonds are perfect substitutes. This implied that the expected yields on domestic and foreign bonds are equalized. In effect, apart from their currency of denomination domestic and foreign bonds are regarded by international investors as the same. In this chapter we examine the portfolio balance model which is distinguished from the monetary models because it allows for the possibility that international investors may regard domestic and foreign bonds as having different characteristics other than their currency of denomination. In particular, they might for various reasons regard one of the bonds as being more risky than the other. This being the case they will generally require a higher expected rate of return on the bond that is considered more risky to compensate for the additional risk it entails.