The Asset Approach to the Exchange Rate: Portfolio Balance Models of the Exchange Rate and the Current Account

Abstract

We will now relax the assumption that interest-bearing assets denominated in different currencies are perfect substitutes in portfolios and that agents are risk-neutral. In this chapter we will consider the more general setting in which agents are risk-averse and assets are imperfect substitutes. As a result the UIP condition will no longer hold and, therefore, the risk premium need not be zero. At any point in time the nominal exchange rate will be determined by portfolio balance considerations; over time the exchange rate will be driven by the current account and by the evolution of expectations. Since the current account adds an additional relation to the dynamics of exchange rate determination, and in order to focus attention on the role of the current account and of expectations in the evolution of the exchange rate, we will eschew any consideration of sluggish adjustment in prices. In fact, and throughout this chapter, we will maintain the assumption that wages and prices adjust instantly to ensure that full employment output prevails and that PPP holds at all times. The outline of this chapter is as follows. In Section 3.2 we employ a mean-variance analysis to build the asset sector of the model. In Section 3.3 we consider the short-run response of the exchange rate to monetary policy changes and to changes in expectations.