Portfolio Balance Model PDF

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The Portfolio Balance Model • 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: Domestic and foreign bonds are not perfect substitutes: expected returns on both assets are not equal: UIP does not hold

• Conditions for risk premium to exist: 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 3 conditions are fulfilled, UIP does not hold.

• r — r*= ES ! + RP • RP = risk premium demanded for domestic bonds, which can be either + or — .

• Different types of risk: • A) Currency risks: inflation rates in the domestic and foreign economies are uncertain • Real interest rate will also be uncertain • Risk of holding a bond: function of the inflation rate domestic — domestic, foreign — foreign • Exchange rate risk: expected deviation of the exchange rate from PPP • Expected rate of return from holding foreign bonds = r* — EP !* + ES !

• Expected rate of return from holding foreign bonds = r* — EP !* + ES ! • Country risks: • A) Exchange rate risks: 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. • B) Default risk: government refuses to pay interest/principal on bonds issued by them and denominated in a foreign currency (only) • Bonds denominated in domestic currency can be redeemed by printing money • C) Political risk: Risk of loss of investment due to changes in political environment • RISK MAKES BONDS IMPERFECT SUBSTITUTES

Portfolio balance model • OMO, FXO or SFXO creates disturbances in asset holders’ portfolios • 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 • Implications for exchange rate and domestic interest rate • Circle continues till model is restored to long- term equilibrium. The Operation of the Portfolio Balance Model

•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

Assumptions: • Fixed domestic and foreign prices

• Fixed real domestic output

The Model • 3 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

• B = Fixed net supply of domestic bonds • Foreign bonds: held by private agents or authorities. Assumed positive and equal to the sum of all previous CA surpluses

• Holdings can increase/ decrease via CA surplus/ deficit • M= Domestic monetary base: Liability of the authorities= assets of the authorities

• Total private financial wealth (W) • SFp: 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

• Demand to hold domestic bonds • Demand to hold foreign bonds

Equilibrium of the Model • Asset market is in equilibrium when all 3 markets clear at the appropriate interest and exchange rates • MM: Equilibrium in the domestic money market • Upward sloping: - Depreciation of S - Increase in domestic currency value of foreign bonds - Increase of wealth - 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: - Can only be offset by a drop in r • Increase in supply of B: - Rise in r - Rightward shift of BB • FF: Equilibrium in the foreign bond market • Downward sloping: - Rise in r: B become more attractive than F - Appreciation of domestic currency • Increase in supply of foreign bonds (assuming fixed r*): - Fall in r for F to be willing held: - FF shifts to the left • FF steeper than BB: • Changes in r affect the demand for domestic bonds more than the demand for foreign bonds

Effects of a FXO • Authorities purchase F from private sector with newly created money base • Increase in private sector’s holdings of money and equivalent fall in their holdings of foreign bonds

• MM shifts to the right • FF shifts to the right • Exchange rate depreciates and r drops (point B) • Exchange rate depreciation: FXO creates shortage of foreign assets in agents’ portfolios which can only be compensated by a depreciation of S: - Makes remaining foreign assets in portfolio more valuable - Fall in interest rate: encourages agents to hold increased money stock 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 • BB shifts left • Excess supply of money: - Demand for bonds increases - Fall in interest rate - Depreciation of exchange rate - Value of foreign bonds rises

Effects of a SFXO • SFXO = expansionary FXO + contractionary OMO of equivalent amount • 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 • Increase in r: excess supply of foreign bonds depresses its price and r rises

• Portfolio balance model: domestic and foreign bonds are different assets • 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

Comparison of an omo, SFXO and FXO • 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: - Rise in interest rate discourages investment - Depreciation encourages net exports

Dynamics of the Model • LR: current account should be balanced, change in exchange rate=0: • Country neither increases, nor decreases foreign bond holdings. • Exchange rate: equilibrium

•t1: OMO/FXO/ SFXO produces depreciation of the exchange rate •Prices fixed: real exchange rate depreciation •CA surplus •Accumulation of foreign bonds

• Increased proportion of foreign bonds in portfolio • Purchase of domestic bonds to reduce risk exposure • Appreciation of exchange rate • Reduction of CA surplus till balance is met • Long run exchange rate Ŝ lies below S: • Interest of holding foreign assets goes into service account • Appreciation necessary so that deterioration of trade account offsets improvement in service account 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 • CA improves

Money vs bond - financed fiscal expansion • 2 ways to finance government expenditure: 1. Printing extra money 2. Selling bonds to agents 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

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...