Monetary Policy Trade-Offs in a Portfolio Model with Endogenous Asset Supply

This paper describes the development of a portfolio balance model for an open economy with endogenous asset supply. Domestic producers finance capital goods through credit and bonds according to debt capital costs as well as equity assets. Private households hold a portfolio of domestic and foreign assets, shift balances depending on asset returns and maximize real consumption according to the real exchange rate. In this environment, the central bank is able to stabilize the exchange rate and the real domestic production at the same time without necessarily provoking changes in the domestic price and interest rate levels. By a portfolio balance approach with maximizing behavior and balance sheet relations in stock and flow figures, I obtain two sets of general equilibrium conditions (short term, long term). GEMs are solved. Theoretical implications are shown by VAR-Models (4 countries). It results that the central bank is able to stabilize the exchange rate in reaction to changes in the foreign interest rate and the country risk level by interventions on the market of domestic bonds and foreign assets as well as by adjusting credit supply. By the relations, it is revealed that exchange rate stabilization is connected with the stabilization of real domestic production through the preservation of the real amount of domestic capital investment. The central bank has to adjust its stocks of domestic and foreign assets as well as the amount of credit but nevertheless, it is able to neutralize side effects on remaining variables in the long time. Neither changes in domestic interest rate levels nor changes in the price level of domestic goods need to be produced. Consequently, it results that monetary policy trade-offs generated by exchange rate stabilizing interventions can be reduced to a minimum level.