Page 17 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.k: Explain the potential effects of READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
monetary and fiscal policy on exchange rates.

MODULE 11.3: EXCHANGE RATE DETERMINANTS, CARRY TRADE, AND
CENTRAL BANK INFLUENCE

PORTFOLIO BALANCE APPROACH TO EXCHANGE RATE DETERMINATION

Focuses only on the effects of fiscal policy (and not monetary policy). While the Mundell-Fleming model focuses on the short-
term implications of fiscal policy, the portfolio balance approach takes a long-term view and evaluates the effects of a
sustained fiscal deficit or surplus on currency values.

EFP (Fiscal deficit), means G borrows money from investors; they evaluate the debt based on expected risk and return (A
sovereign debt investor would earn a return based on both the debt’s yield and its currency return).

Investor see EFP as requiring risk premium but they perceive that the yield and/or currency return is sufficient, they continue to
purchase the bonds. However, if the deficits become unsustainable, investors may not fund—leading to currency depreciation.

Combining the Mundell-Fleming and portfolio balance approaches, we find that:
• Short term: With free capital flows, an EMP leads to domestic currency appreciation (via high interest rates).
• Long term: The government has to reverse course (through tighter fiscal policy) leading to depreciation of the domestic
currency. If the government does not reverse course, it must monetize its debt (i.e., print money—monetary expansion),
which would also lead to depreciation of the domestic currency.