How financial Crisis Effect the Dynamics of Exchange rate? Revisit the Portfolio Balance Model in the presence of financial Crisis

Abstract In this paper the influence of financial crisis on dynamics of exchange rate is captured by modifying the Portfolio balance model of Branson et al. (1985). This modification is based on the assumption that financial crisis originates in a foreign country and transmits to a small country via financial markets. It alters the preferred portfolio composition by influencing the need for domestic and international bonds. After establishing the basic conceptual framework, the effect of financial crisis on exchange rate is investigated in two scenarios. First case has considered a small domestic economy with no internal crisis. The emergence of a financial crisis in this case causes the currency to appreciate by rising demand for domestic financial assets while decreasing demand for international financial assets. Case two has considered the opposite economy which is experiencing a serious internal crisis at the time of external financial crisis. Hence, financial crisis originated in the foreign country affects the small country’s growth by reducing its ability to attract the capital funds from abroad. The domestic investor then speculates that financial crisis further worsens the economic growth and weakens the domestic currency which further makes the domestic bond relatively riskier than foreign bond. This motivates them to change the structure of portfolio investment by shifting their money out of domestic bonds to foreign bonds and consequently it depreciates the domestic currency. Finally, the empirical validity of second case is confirmed for Pakistan.