On the theory of international currency portfolios

Abstract The paper develops a general equilibrium theory of the optimal currency composition of international bond portfolios. Like the partial equilibrium portfolio balance literature of the 1980s, the theory emphasizes the critical roles of government debt and government balance sheet operations in the determination of portfolios, prices and allocations. Consistent with empirical findings, optimal foreign currency positions are found to be small, with their size decreasing with exchange rate volatility, while optimal domestic currency positions are large and increasing with domestic interest rates. A large open market purchase of domestic currency bonds from private households lowers domestic interest rates.