In this paper we develop a portfolio balance model which can be used to make an equitable comparison of alternative exchange rate regimes. Our point of departure from standard portfolio models is that we derive all asset demand functions from microeconomic behavior. As Helpman and Razin (1979) and Lapan and Enders (1980) have observed, all asset demand and expenditure functions used in a comparison of exchange rate systems must be consistent with individual optimizing behavior. This seemingly innocuous observation implies that many of the macroeconomic comparisons of fixed and flexible exchange rates are not legitimate. Inherent in any portfolio balance model is the implication that asset demand functions depend upon the joint distribution of asset yields. As long as there are different risks in different exchange regimes, portfolio allocation rules will change when the exchange rate regime changes.
Available at: http://works.bepress.com/harvey-lapan/5/