Abstract

Trade Balance and Portfolio Theorie of Exchange Rates: A Graphic Illustration

Although exchange rate theory has made substantial advances in recent years with the portfolio or asset market approach, even now many students still find themselves confronted with textbooks and lectures with choose, at least as a point of departure, the traditional exchange rate explanation using the familiar supply/demand diagram used for the goods markets. This flow approach was gradually displaced with the introduction of portfolio theory by an asset-holding approach to exchange rate explanation. The latter requires that at all times the exchange rates assume a level at which economic entities are still just prepared to hold assets in various currencies. That on this basis trade flows are in many instances unjustifiably neglected has been demonstrated in a diversity of research studies. The object of the present essay is to explain the exchange rate-determining role of the trade balance within the framework of the portfolio approach in the simplest possible, didactically easily accessible manner. Since a trade balance disequilibrium leaves the offers of assets in the currencies involved unaffected, any exchange rate change must be attributed to shifts in the demand for assets. The latter may occur because an unsquared trade balance may be connected with asset redistributions between home and abroad. The decisive factor for the exchange rate is the currency form in which it is desired to build up or reduce assets at home and abroad. The usual exchange rate reaction to a trade balance disequilibrium occurs when – at the original exchange rate – people at home and abroad have a preference to execute the great majority of asset changes in their own currency. This result can be derived in a simple manner with a graphic presentation. Graph analysis also seems to make it evident that with other preference constellations an abnormal reaction of the exchange rates is possible.