Question

State the demand function of the three primary assets under the portfolio balance approach to the balance of payments and explain the relationship between the foreign interest rate and the demand for each asset.

Answer 1

The demand function for the three primary assets - money, bonds, and stocks - under the portfolio balance approach to the balance of payments is influenced by variables like income, interest rates, and inflation. The demand for money is determined by the need for liquid assets, while the demand for bonds and stocks is driven by fixed income preferences and profit expectations, respectively.

Step-by-step explanation:

Under the portfolio balance approach to the balance of payments, the demand function of the three primary assets - money, bonds, and stocks - can be represented as follows:

• Demand for money: The demand for money is determined by the desire to hold liquid assets for transactions and precautionary purposes. It is influenced by variables like income, interest rates, and inflation.
• Demand for bonds: The demand for bonds is driven by the desire for fixed income investments. As interest rates rise, the demand for bonds decreases due to the opportunity cost of holding bonds over other assets.
• Demand for stocks: The demand for stocks is influenced by the expectation of future profits. If foreign interest rates increase, it may lead to a decrease in the demand for stocks as investors may find it more attractive to invest in foreign assets.