Portfolio Balance Approach Research Articles

Exploring counter-cyclical monetary policy in a small open economy using the portfolio balance approach

Whether or not the money supply is endogenously determined in response to demand variations has been the subject of recent debates. Regardless of the answer to this question, central banks can and do react to cyclical fluctuations, and their responses, in turn, affect the balance of payments and the foreign asset position. We explore the feasibility of a counter-cyclical monetary policy rule in a small open-economy portfolio balance set-up where assets are imperfect substitutes, capacity utilization endogenously adjusts in a neo-Kaleckian manner to clear the goods market, the exchange rate is flexible, and prices are fixed. This set-up, under some non-restrictive conditions, generates a stable steady-state solution, suggesting that a monetary policy based on a counter-cyclical interest-rate rule is a viable option for macroeconomic stabilization.

Testing Portfolio Balance Approach to Exchange Rate during Managed Float: An Empirical Evidence from India

Any global economic and financial disturbance affects trade and capital flows of our economy through exchange rate movements. The portfolio balance (PB) approach considers the capital flows as an additional variable explaining the exchange rate movements. This approach assumes domestic and foreign bonds to be imperfect substitutes. The bonds bearing high risk carry comparatively higher return in the form of risk premium. This study attempts to re-examine the empirical soundness of the PB model in respect of Indian rupee/ US dollar (INR/US $) exchange rate. It covers the period from 2000: 1 to 2023:1. Augmented Dickey Fuller test and Phillip Perron tests are used to test stationarity property of the variables. The Ordinary Least Square (OLS) methodology of regression is used for the purpose of estimation. Autocorrelation problem is dealt with by using the Cochrane Orcutt procedure. The PB model is estimated in naïve form as well as in partial adjustment form. The empirical finding shows that the PB model works well in partial adjustment framework rather than in its naïve form with speed of adjustment being three to four quarters. The money supply differential and relative real Gross Domestic Product (GDP) are identified as significant variables whereas the bond holding variable remained insignificant. However, in the long run, the model did not work. It is suggested that the fiscal and monetary policies that enhance capital spending in productive sectors should be implemented to achieve a gradually appreciating exchange rate.

Theories of Exchange Rate Determination: A Brief Theoretical Review

This paper endeavored to categorise and evaluate exchange rate theories. These theories included the International Fischer's Effect Theory, the Purchasing Power Parity Theory, the Interest Rate Parity Theory, the Balance of Payments Theory, the Monetary Approach to Foreign Exchange, and the Portfolio Balance Approach. The paper analyses these theories' advantages and disadvantages. Keywords: Exchange Rate; Purchasing Power Parity Theory; Interest Rate; Portfolio Balance Approach; Monetary Approach; Foreign Exchange DOI: 10.7176/EJBM/14-20-08 Publication date: October 31 st 2022

Dynamic relationship between exchange rates and stock prices for the G7 countries: A nonlinear ARDL approach

• We examine the relationship between stock prices and exchange rates in G7 countries. • In the short -run, both the flow-oriented and the portfolio balance approaches are supported. • A nonlinear ARDL model shows that rising and falling stock prices have differential long-run impacts on exchange rates. • Our tests provide long-run support for the portfolio balance approach, but not for the flow-oriented approach. This paper employs linear and nonlinear ARDL models to examine the short-run and long-run relationship between stock prices and exchange rates in the G7 countries. Both the flow-oriented approach that exchange rates affect stock prices and the portfolio balance approach that stock prices affect exchange rates are supported in the short-run. Neither model is supported in the long-run using linear ARDL models, but the nonlinear ARDL model shows evidence supporting the portfolio balance approach in four of the countries. In these four countries we find that rising and falling stock prices have significant long-run effects on their exchange rates. Furthermore, Granger causality tests confirm that causality runs from stock prices to exchange rates in six of the countries. Thus, the use of a longer and more recent data set provides stronger long-run support for the portfolio balance approach than found in most of the recent literature, while we confirm results of recent research showing no long-run evidence of causation running from exchange rates to stock prices.

Volatility spillover analysis between stocks and exchange rate markets in short and long terms in East European and Eurasian countries

PurposeThis paper researches a bidirectional volatility transmission effect between stocks and exchange rate markets in the six East European and Eurasian countries.Design/methodology/approachResearch process involves creation of transitory and permanent volatilities via optimal component generalized autoregressive heteroscedasticity (CGARCH) model, while these volatilities are subsequently embedded in Markov switching model.FindingsThis study’s results indicate that bidirectional volatility transmission exists between the markets in the selected countries, whereas the effect from exchange rate to stocks is stronger than the other way around in both short-term and long-term. In particular, the authors find that long-term spillover effect from exchange rate to stocks is stronger than the short-term counterpart in all countries, which could suggest that flow-oriented model better explains the nexus between the markets than portfolio-balance approach. On the other hand, short-term volatility transfer from stock to exchange rate is stronger than its long-term equivalent.Practical implicationsThis suggests that portfolio-balance theory also has a role in explaining the transmission effect from stock to exchange rate market, but a decisive fact is from which direction spillover effect is observed.Originality/valueThis paper is the first one that analyses the volatility nexus between stocks and exchange rate in short and long term in the four East European and two Eurasian countries.

Interaction Effect of Capital Controls and Macroeconomic Policies

This study highlights recent approaches to reducing capital flow volatility using capital controls. Through a SVAR model, variance decomposition and shocks analysis, applied to 22 developed and developing countries over the period between 2000 and 2017, this study examines the effectiveness of capital controls in reducing capital flow volatility. The results show that the portfolio balance approach of capital controls can be applied and enables to predict capital inflow movements. The findings show asymmetric impacts of capital controls, where a floating exchange rate allows capital controls to be more effective compared to a fixed exchange rate. Furthermore, controls on capital inflows are more useful than controls on outflows. This study found that the exchange rate policy is more responsive to capital controls actions compared to the monetary policy.

The Relationship Between Stock Prices and the Real Exchange Rate Index in BRICS Countries: Symmetric and Asymmetric Causality Analysis

This study investigates the causality relationship between the real exchange rate index and stock prices in Brazil, Russia, India, China, and South Africa (BRICS) countries over the period from March 2003 to June 2018. The relationship between the variables was made with symmetrical and asymmetrical causality tests within the framework of traditional approach and portfolio balance approach. Accordingly, Hacker-Hatemi-J (2006) test was used for symmetric analysis and Hatemi-J (2012) causality test was used for asymmetric analysis. According to the results of the analysis, the causality relationship between the mentioned variables is different in BRICS countries. The findings do not provide definitive evidence in favor of the traditional approach or portfolio balance approach. Also, it can be stated that there are noisy transactions in these two markets Key Words: BRICS, Stock Prices, Real Effective Exchange Rate, Symmetric and Asymmetric Causality AnalysisJEL Classification: C32, F31, G10, G15

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.

Portfolio Balance Approach to Asymmetries, Structural Breaks and Financial Crisis: Testing a Model for Nigeria

This study tests the Portfolio Balance Theory (PBT) for Nigeria for the period starting from September 1997 to September 2018. It extends the hypothesized linear inverse relationship between exchange rate and stock price to include asymmetries and structural breaks. It further examines the impact of the 2008 global financial crisis on the PBT to determine its stability after the crisis. The full sample results show that the PBT holds for Nigeria and asymmetries and structural breaks matter in the nexus between stock price and exchange rate. However, the impact of stock price on exchange rate diminished in the long-run with the advent of the 2008 global financial crisis, thus eroding the relative consistency of the PBT after the crisis. The sensitivity of the Nigerian exchange rate to stock price changes calls for the strengthening of the stock market performance through relevant policies including the enhancement of portfolio diversification and risk-hedging assets. The role of asymmetries should not also be jettisoned in predicting exchange rate with stock prices to obtain accurate forecast results.

INTERDEPENDENCE BETWEEN STOCKS AND EXCHANGE RATE IN EAST ASIA — A WAVELET-BASED APPROACH

This paper investigates whether the portfolio-balance approach or the flow-oriented theory better explains the connection between stocks and exchange rate in various time-horizons in the four East Asian countries — Indonesia, Thailand, South Korea and Japan. For the analysis, we use different approaches of the wavelet methodology — wavelet correlation, wavelet coherence and wavelet cross-correlation. Wavelet correlations suggest that negative correlation is dominant across the wavelet scales in the emerging East Asian markets, which indicates that the portfolio-balance approach, that is, capital mobility stands behind this nexus. For the Japanese case, we find positive wavelet correlation across the scales, which suggests that the flow-oriented model or current account explains the interlink. Results of wavelet coherence are in line with the wavelet correlation results, and these results provide an additional evidence that investors’ panic during World financial crisis was the main culprit behind the massive financial fund reallocation in the all emerging Asian markets.

The portfolio theory of inflation and policy (in)effectiveness

Abstract The analysis of open macroeconomies typically assumes (implicitly or explicitly) that resource allocation decisions are taken by domestic agents. The Portfolio Theory of Inflation (PTI) developed in this study assumes that some critical allocation decisions are taken by global investors and investigates how such decisions affect the effectiveness of macroeconomic policy in open and highly financially integrated economies. The PTI adopts a modified version of the portfolio balance approach to exchange rate determination and incorporates optimal intertemporal choices from global investors who allocate resources internationally based, inter alia, on the perceived policy credibility of the national authorities and their policies. The PTI shows that when a country has low credibility and is heavily indebted, investors hold its economy to a tighter intertemporal budget constraint and policies aimed to stimulate output growth do in fact dissipate into currency depreciation and higher inflation, with limited or no impact on output. On the other hand, high credibility creates space for effective and non-inflationary macro policies with limited impact on nominal variables.

Analysis of relationship and volatilities between foreign exchange market and stock market of Thailand and selected Asian countries

The purposes of the research are to investigate the relationship between Thailand stock market and exchange rate and to investigate the effect of Thailand stock market (SET Index) and exchange rate on the exchange rate of selected ASEAN countries, namely Malaysia, Indonesia and Singapore. The estimation method is DCC GARCH (1,1) which allows for the conditional correlation structure to be time-varying. The daily data between 2000-2016 are used for the estimation. The results find that Thailand stock market and exchange rate have one way relationship from the stock market to the exchange rate which is based on the concept of Portfolio Balance Approach. When the return of stock price index increases, Baht will appreciate. The increase in return of stock price index by 1 percent will lead to Baht appreciation by 0.0089 percent to 0.0109 percent. Additionally; Thailand stock market and exchange rate affect Malaysian Ringgit. The highest value of dynamic conditional correlation is the correlation between Thai Baht and Malaysian Ringgit.

New Evidence on the Portfolio Balance Approach to Currency Returns

This paper re-examines the empirical performance of the portfolio balance approach to currency returns. It considers the implications of two alternative specifications of preferences: one based on expected utility theory and the other on prospect theory. It also uses survey data to estimate models of ex-ante rather than ex-post returns. The empirical analysis relies on the co-integrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both portfolio balance specifications.

Portfolio Balance Approach to Exchange Rate Determination: Testing a Model by Applying Bilateral Data of Turkey and United States1

Turkish economy started to be liberated in the beginning of 1980’s and gradually to be a part of global economic and financial system. But as a result of economic articulation of Turkey to the global world, global economic and financial headwinds have affected trade and economy especially via exchange rates. Since Turkey is of ever-growing foreign trade volume with global economic world determination of fluctuations in exchange rates has increased in importance. Due to global integration of financial markets, inflow and outflow of foreign bonds could cause economic agents to change currency composition of foreign assets to reduce the risks arisen from exchange rates. This situation can negatively affect exchange rates by fluctuating them. Aim of this study is to empirically investigate the portfolio balance effect on exchange rates. In this context, different version of Cushman’s model (2007) using monthly bilateral data of Turkey and U.S. covering the period 2006-2016 will be employed and portfolio balance approach to the exchange rates determination will be tested by performing cointegration test allowing for multiple structural breaks.

Financial Sector and Aggregate Import Demand: A General Equilibrum Perspective with Japan Data

This study explores the role of financial sector on import demand behaviour (the real sector) from general equilibrium perspective, which is based on the portfolio balance approach to capture financial market. Japan’s data support partially this hypothesis given noncointegration finding, while foreign interest rate is significant i.e. reduces Japan’s imports. Growth in foreign income is the most influential factor, and domestic economic growth both make more imports. However, the relative price of domestic goods, and domestic interest rate are insignificant. Japan’s monetary policy (interest rate) is inappropriate in altering the behaviour of imports in Japan, but fiscal policy that influences Japan’s economic growth.

English

Exchange rate plays vital role in an economy and thus has gained much attention in the literature. The purpose of the study is to test the portfolio balance approach which proposes that money supply and bonds of a country impact its exchange rate. For this purpose, Augmented Dickey Fuller and Phillips Perron test have been applied on the quarterly data from 2001 to 2010 to test the stationarity of the data. Auto regressive distributed lag model has been used to analyze the data. Results validate the empirical evidence and reveal that long term relationship is found among the variables. Money supply of US, money supply of Pakistan and bonds for US are having an impact on the exchange rate of these countries. Key words: Portfolio balance approach, exchange rate, money supply, bonds, balance of payments.

Dynamic Analysis of the Stock Price Index and the Exchange Rate Using Vector Autoregression (VAR): An Empirical Study of the Jakarta Stock Exchange, 2001-2004

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General Equilibrium Perspective on Twin Deficits Hypothesis: An Empirical Study with US Results

This study proposes an alternative analytical framework for testing the so-called twin deficits hypothesis from the general equilibrium perspective. The income–expenditure equilibrium takes both the behavioural relationships of the saving and investment into consideration. The empirical results of cointegration tests show that the US fiscal balance, current account balance, real income and interest rates (short- and long-run) are co-movement for the observed periods between 1970Q2 and 2011Q4. Also, the causality tests suggest that budget deficit does indirectly Granger-cause current account deficit via short-run interest rate and real income. The real income and interest rates variables determining the behavioural relationships are important in understanding the US twin deficit slogan. In short, the empirical results validate the twin deficits hypothesis in the USA. Some policy implications have been drawn, especially on the implementation of the “fiscal cliff” policy. This study also recommends portfolio balance approach for future twin deficits research.

A Portfolio-Balance Approach to the Nominal Term Structure

I examine how the maturity structure of outstanding government li- abilities aects the nominal yield curve under a variety of assumptions about investor objectives. In the class of models I consider, equilib- ria are arbitrage free, expectations are rational, and assets are valued only for their pecuniary returns. Nonetheless, a portfolio-balance mech- anism arises through the dependence of the pricing kernel on the return on wealth. This mechanism results in a positive relationship between the duration of bondholders'portfolios and the price of interest-rate risk. Quantitatively, the models suggest that the eects of shifting Treasury supply on yields can be substantial— for example, the increase in the av- erage maturity of U.S. government debt that occurred between 1976 and 1988 may have raised the ten-year yield by 50 basis points. On the other hand, partly re‡ecting an attenuation of portfolio-balance eects when in- terest rates are near zero, the Federal Reserve's asset purchase programs likely had a fairly small impact on the yield curve by removing duration from the market.

The US tech pulse, stock prices, and exchange rate dynamics: Evidence from Asian developing countries

This paper empirically investigates the economic relationship between the US and Asian economies after the Asian currency crisis in Indonesia, Korea, the Philippines, Singapore, and Thailand, employing a cointegration methodology. Based on the empirical results, we conclude that the interdependence between the US and these Asian economies has intensified especially in information technology industries, and that their stock markets are integrated. On the other hand, the relationship between the domestic stock and foreign exchange markets is found to have a negative sign, interpreted by portfolio balance approach, in Indonesia, Korea, and Thailand. This result implies that the exchange rates of these countries are relatively vulnerable to fluctuation in international portfolio investments.