Portfolio Balance Theory (Exchange Rate Determination Theory)

Saturday, September 12, 2009

The portfolio balance theory of the exchange rate is the proposition that the exchange rate adjusts to make the stock of financial assets denominated in units of that currency demanded equal to the stock supplied. For example, the quantity of U.S. dollars supplied is the quantity of U.S. dollar – denominated securities. The total includes securities issued by the government and by firms. It also includes the U.S. money supply. But the money supply is just one part of the total stock of U.S. dollars ---denominated assets. The exchange rate adjusts to make the total quantity of U.S. dollar –denominated assets demanded equal to the quantity supplied.

In studying the forces that determine the exchange rate, we’ll work with the third and broadest theory—the portfolio balance theory.