Business & Management Studies

Abstract

Another theory of exchange rate determination is the (broader) portfolio-balance approach, which is part of the Asset Market Models and is largely attributed to economists after 1978 when the exchange rate had become flexible (market determined). This article first introduces the setting of the model embedded in the portfolio balance approach that encompasses three assets (money, bonds, and stocks) and two returns (interest rate on bonds and stock markets’ returns), which deviates a little from the models and approaches used for the monetary approach to the balance of payment, the overshooting model, and from the associated market equilibrium. The effects of monetary policy, of current account, and of wealth (money, bonds, and stocks or stock market indexes) under the portfolio-balance approach are examined, here, theoretically and empirically. The current statistical and econometric results show that the exchange rate is determined mostly by the money supply, value of the bonds, the level of the stock indexes, and the interest rates; but, there is only a very little effect from the returns of the stock markets. All these variables are affected by the monetary policy. Thus, the central banks are the institutions that cause the effects on these independent variables and consequently, on the exchange rate (as a monetary phenomenon).