EC3012 - Week 10 - The Portfolio Balance Model PDF

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EC3012 – International Finance – Week 10 The Portfolio Balance model Introduction This model allows for there to be differences between domestic and foreign bonds by having different characteristics other than their currency.  OMO - Open market operation, exchange of already existing domestic money base for domestic bonds and vice-versa.  FXO - Foreign exchange operation, exchange of already existing domestic money for foreign bonds and vice- versa.  SFXO - Sterilised foreign exchange operation, exchange of domestic bonds for foreign bonds and vice-versa. Leaving monetary base unchanged.

Risk Premium As bonds now differ, the condition of UIP no longer holds. The risk premium is the extra return expected on a bond which is perceived to be riskier. Conditions for risk premium: 1. perceived different risks between foreign and domestic bonds. Risk= uncertain expected return 2. Risk aversion on the part of economic agents to perceived differences in risk. I creased risk will only be taken if expected real returns compensate. 3. Theoretical “risk minimizing portfolio”: If not held, agents will demand a risk premium to compensate. If all three of the conditions are fulfilled, UIP does not hold. Risk premium is: ¿

r−r =E s´ + RP The RP can be either positive or negative as it represents the risk premium demanded for domestic bonds.

Different Types of Risk There are two main categories, Currency risks and Country Risks. Currency Risks:  Inflation Risk: As inflation is uncertain both domestically and internationally, it means the return on an asset is uncertain. The risk of a bond would be a positive function of the variance of inflation. 

Exchange Risk: The deviation of the exchange rate from PPP is the level of risk as the ¿ expected rate of return for holding foreign bonds is r −E p´ + E s´ Country Risks:  Exchange Control Risk: Investors face uncertain real rates of return due to the risk of imposition of a tax on the interest element during the holding period of a bond.  Default Risk: the risk associated with the likelihood of a country defaulting on a bond.  Political Risk: Risk of loss of investment due to changes in political environment.

Portfolio Balance Model Pioneered by William Branson and Pennti Kouri (1976-1984). OMO, FXO and SFXO creates disturbances in asset holders’ portfolios requiring a change in exchange rate and domestic interest rate. Change in exchange rate and domestic interest rate. Effects on output and CA. Current account surplus/ deficit: accumulation/deaccumulation of foreign assets. Changes in asset holder’s portfolios. 1

Implications for exchange rate and domestic interest rate. Circle continues till model is restored to long- term equilibrium.

The Model Assumptions:  Small country: can influence its real exchange rate without provoking reactions from the rest of the world.  Domestic assets are held only by domestic residents.  Fixed domestic and foreign prices.  Fixed real domestic output. Three assets held in portfolios of private agents and authorities: 1. M: domestic monetary base 2. B: domestic bonds denominated in domestic currency 3. F: Foreign bonds denominated in foreign currency. Domestic bonds: held either by private domestic agents or authorities. So the net supply of bonds is assumed fixed as:

B´ =BP + B a The countrys holdings of foregin bonds held by private agents or authorities is assumed positive and equal to the sum of all previous CA surpluses. Assumed to fluctuate over time via a CA surplus or deficit. FP is holdings of private agents, R is holdings by authorities as forex reserves.

F= FP+ R Domestic monetary base: Liability of the authorities= assets of the authorities. S is exchange rate as domestic per unit of foreign.

M =Ba +SR Total private financial wealth (W) at any given time:

W =M + B P +S F P Where SFp is an excess of demand for foreign bonds can be partly met by the depreciation of the domestic currency (rise in the price of F). Demand for domestic currency, with partial derivatives:

M =m ( r , E s´ , Y ,W ) withmr 0 Demand to hold domestic bonds, with partial derivatives:

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B P =b ( r , E s´ , Y ,W ) withb r >0, b´s 0 Demand to hold foreign bonds, with partial derivatives:

SF P= f ( r , E ´s ,Y , W ) with f r < 0, f ´s > 0, f y 0 Equilibrium of the model

MM: Equilibrium in the domestic money market. Upward sloping as a depreciation of S increase in domestic currency value of foreign bonds. Increase of wealth leads to an increase in demand for money that can only be offset by a rise in domestic interest rate. Increase in money supply: fall in r: MM shifts right BB: Equilibrium in the domestic bond market. Downward sloping: Depreciation increases wealth. Demand for bonds increases which can only be offset by a drop in r. An increase in the domestic bond supply for a given exchange rate requires a rise in r for the bonds to be willingly held, a rightward shift of BB. FF: Equilibrium in the foreign bond market. Downward sloping as a rise in r makes B become more attractive than F leading to an appreciation of domestic currency as more domestic bonds are purchased. Increase in supply of foreign bonds (assuming fixed r*) requires a fall in r for F to be willingly held. FF shifts left. FF is steeper than BB on the assumption that changes in domestic rate of interest affect the demand for domestic bonds more than for foreign bonds.

The effects of a foreign exchange operation (FXO)

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Here the authorities purchase foreign bonds from private sector with newly created monetary base. Leads to a rightward shift of MM and FF as there is an increase in private sectors holdings of money and equivalent fall in their holdings of foreign bonds. Therefore, exchange rate depreciates, and r drops (point B).

The Effects of an OMO

Expansionary OMO: Authorities increase private sector holdings of money and decrease holdings of domestic bonds by an equivalent amount. OMO: Leaves FF unchanged, MM shifts right and BB shifts left. Excess supply of money so demand for bonds increases results in a fall in interest rate. The exchange rate depreciates, and the value of foreign bonds rise.

The effects of a sterilized foreign exchange operation (SFXO)

Authorities purchase foreign bonds with newly created money base. Increase of monetary base offset by sale of domestic bonds. Monetary base remains unchanged. Increase of supply of domestic bonds: BB shifts right. Reduced holdings of foreign assets by private agents. FF moves to the right. MM unchanged: monetary base unaffected. Depreciation of the exchange rate: Shortage of foreign assets in agents’ portfolios requires an increased value of remaining foreign assets in portfolios. 4

Increase in r: excess supply of foreign bonds depresses its price and r rises. SFXO increases agent’s holdings of domestic bonds and decreases agents’ holdings of foreign bonds: Disequilibrium in agents’ portfolios: More domestic bonds than agents want: Portfolio is more exposed to domestic risks: Equilibrium in agents’ portfolios is restored by a higher interest rate to compensate increased risk. Depreciation of exchange rate reduces risk exposure by revaluing remaining holdings of foreign assets.

Differing effects of an FXO, OMO and SFXO

FXO: Larger depreciation of the exchange rate: excess of demand of foreign bonds OMO: Larger fall in domestic interest rate: excess of demand for domestic bonds Assuming income is not fixed: expansionary effect of an FXO on income will depend more on the responsiveness of the trade balance. Expansionary effect of OMO will depend more on responsiveness of investment to a fall in interest rate. SFXO has relatively weaker effect then FXO on exchange Opposite interest rate effects. FXO:    

Increase in money stock Lowers r Encouraged demand for F Greater depreciation

SFXO:    

Increases stock of domestic bonds Higher domestic interest rate Foreign bonds become less attractive Limits the exchange rate depreciation

Effects on output of a SFXO are ambiguous as a rise in interest rate discourages investment and a depreciation encourages net exports.

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Dynamics of the model

In the long run: current account should be balanced, change in exchange rate=0: Country neither increases, nor decreases foreign bond holdings and Exchange rate in equilibrium.

Effects of a change in risk perceptions Assumption: foreign bonds become riskier. Decrease in demand for foreign bonds FF shifts left. Increased demand for domestic bonds: BB moves to the left. New intersection at point B, S appreciates, and r falls due to increased demand for domestic bonds. S appreciation: CA deficit, decline in foreign asset holdings, Shortage of foreign bonds in portfolios, Depreciation of S and CA improves.

Money vs bond- financed fiscal expansion There are 2 ways to finance government expenditure, either print more money or sell bonds. Money – financed expenditure: Rise in investors wealth: more money and same number of domestic and foreign assets. MM shifts right, Increase in demand for both, foreign and domestic bonds. FF shifts right. BB shifts left. S depreciates and r drops

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Bond- financed expenditure: Bond sales reduce agents’ holdings of money, but money is put back into circulation through increased government spending. Increase in supply of bonds BB shifts right. Increased investor’s wealth: same holdings of domestic and foreign assets plus extra holdings of money. Increase in demand for domestic bonds. Reduction of extent of rightward shift of BB. Increased in demand for money: MM shifts left. 2 effects on foreign bonds. 1. Increased demand due to increased wealth: FF shifts right. 2. Rise in domestic interest reduces demand for foreign bonds making FF rightward shift smaller.

a) Wealth effect dominates:  

Higher interest rate S depreciation

b) Interest effect dominates:  

Higher interest rate S appreciation

Conclusion: fiscal policy will have an ambiguous effect on the exchange rate

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