A Portfolio Balance Model of the Open Economy

This paper develops a framework in which to investigate the effects of macroeconomic policies. The key building blocks are those of Metzler (1968, 1973) in the form of a wealth saving relation and the emphasis on portfolio considerations; the model in its dynamic aspects is extended in a manner suggested in the work of Foley/Sidrauski (1971) and Mussa (1973), where the asset accumulation implied by short-run equilibrium is pursued over time. A large body of literature on the implications of asset mobility for macroeconomic policy has been accumulated during the last decade. Following the work of Mundeli (1968) on capital mobility and the policy mix, that literature has primarily taken a perspective of stabilization policy and therefore espoused a shortrun view of the economy in describing it in terms of the IS-LM model – more or less appropriately modified – to accommodate the openness of the economy and the mobility of assets.1 Alternative routes with a longer time perspective, though still maintaining the assumption of a perfectly elastic supply of output at current prices, have been offered by McKinnon (1969), Tower (1972) and Branson (1972). The approach taken here assumes flexibility of relative prices, full employment and continuous market clearing, thereby assuming away a host of interesting short-run problems and substituting a set of issues that center on the time path of the economy, the endogeneity of asset supplies and the long-run effects of policies. In sections 2 and 3 of this paper the basic model and its equilibrium properties are developed. Section 4 considers three applications of the model, and in section 5 some observations on possible extensions and limitations of the model are offered.