The applicability of the portfolio balance model of exchange rate determination to the Australian dollar

Two issues represent a substantial and continuing challenge to the central bank of a small open economy. The first relates to the correct identification of the 'mix of domestic and external influences on the exchange rate. Correct identification is a first step toward the formulation of a coherent domestic commercial policy: one which provides desired domestic and external policy outcomes. The second requires a clear understanding of the mechanisms of control; the channels of influence open to the central bank if they are able to meet policy targets. In order to address these two issues, the analysis develops a portfolio balance model of exchange rate determination incorporating the role of central bank foreign exchange market intervention behavior. The portfolio balance model is a short term one, restricted to periods of less than one year where the exchange rate is viewed as an asset price influenced by changes in the demand and supply of domestic money, domestic and foreign currency denominated financial assets. Incorporation of central bank behaviour into the model expands a private sector driven view of exchange rate determination into one where there is a role for both private and public sector foreign exchange market behaviour. A further issue, which builds on the first mentioned above, is the impact of public sector behaviour on private sector participants in the exchange rate determination process. The relationship between the two sets of participants in the foreign exchange market - public and private - is reflected in the effects of central bank intervention on the decisions made by private sector investors. The risk premium required by for example, foreign investors holding a domestically denominated asset may alter with central bank action in the foreign exchange market The influence of intervention activity is not confined to the relationship between central bank intervention and the foreign exchange risk premium but also to the more fundamental issue of whether there is a risk premium or not.