Why Do the Monetary Approach and the Portfolio Balance Approach

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The Answer is The monetary approach and the portfolio balance approach have different expected signs for the impact of a change in the domestic interest rate on the exchange rate because they are based on different underlying assumptions and mechanisms.

The monetary approach, also known as the asset market approach, focuses on the relationship between the money supply, interest rates, and the exchange rate. According to this approach, an increase in the domestic interest rate will lead to an inflow of foreign capital seeking higher returns on domestic assets. This increased demand for domestic currency will cause the exchange rate to appreciate. Therefore, the monetary approach expects a positive relationship between domestic interest rates and the exchange rate.

On the other hand, the portfolio balance approach emphasizes the role of asset prices and portfolio allocation decisions in determining exchange rates. According to this approach, an increase in the domestic interest rate will lead to a shift in portfolio preferences towards domestic assets, as they offer higher returns. This shift in demand for domestic assets will lead to an increase in the demand for domestic currency, causing the exchange rate to appreciate. Therefore, similar to the monetary approach, the portfolio balance approach also expects a positive relationship between domestic interest rates and the exchange rate.

In summary, both the monetary approach and the portfolio balance approach expect an increase in the domestic interest rate to lead to an appreciation of the exchange rate. This is because higher domestic interest rates attract foreign capital and lead to a shift in portfolio preferences towards domestic assets, both of which increase the demand for domestic currency and cause the exchange rate to appreciate. Therefore, despite their different theoretical foundations, both approaches have the same expected sign for the impact of a change in the domestic interest rate on the exchange rate.

Why Do the Monetary Approach and the Portfolio Balance Approach

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