Model Answer
0 min readIntroduction
Exchange rates, representing the price of one currency in terms of another, are pivotal in international trade and finance. Determining these rates has been a subject of debate among economists. Two prominent approaches are the Portfolio Balance (PB) approach and the Monetary approach. The Monetary approach, dominant in the 1970s, posits that exchange rates are primarily determined by relative money supply and demand. However, the PB approach, gaining traction later, emphasizes the role of asset markets and investor preferences in influencing exchange rate movements, challenging the purely monetary view.
Portfolio Balance Approach
The PB approach, developed by James Porteous, argues that exchange rates are determined by the demand and supply for domestic and foreign assets. Investors hold a portfolio of assets (bonds, equities, etc.) seeking to maximize returns while diversifying risk. Changes in relative asset returns, risk perceptions, and investor preferences lead to shifts in portfolio composition, influencing capital flows and, consequently, exchange rates. It considers a wider range of assets than just money.
Monetary Approach
The Monetary approach, pioneered by Robert Mundell and Marcus Fleming, views exchange rates as determined by the relative money supplies and the demand for real money balances. It assumes perfect capital mobility and fixed prices in the short run. An increase in the domestic money supply leads to depreciation of the domestic currency, as it increases the supply of domestic assets and reduces their relative return.
Key Differences
| Feature | Portfolio Balance Approach | Monetary Approach |
|---|---|---|
| Asset Focus | Broad range of assets (bonds, equities) | Primarily money |
| Role of Money Supply | Indirect influence through asset returns | Direct and primary determinant |
| Investor Behavior | Portfolio diversification and risk aversion | Rational expectations and purchasing power parity |
| Capital Mobility | Assumes imperfect capital mobility | Assumes perfect capital mobility |
The PB approach acknowledges the importance of expectations and risk aversion, which are less emphasized in the simpler monetary model. Furthermore, the PB approach is better equipped to explain exchange rate movements driven by shifts in investor sentiment and asset market conditions.
Conclusion
In essence, while the Monetary approach provides a foundational understanding of exchange rate determination based on monetary factors, the Portfolio Balance approach offers a more nuanced and comprehensive framework by incorporating asset market dynamics and investor behavior. The PB approach is considered more realistic in today’s complex financial landscape, where capital flows are influenced by a multitude of factors beyond just money supply. Both approaches, however, remain valuable tools for analyzing exchange rate movements.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.