Which is true about the asset market approach?

Question

BlackTom AI · Accepted Answer

The asset market approach posits that exchange rates are determined by investor portfolio choices: people compare expected returns on domestic and foreign financial assets (bonds, equities), and demand shifts until returns are equalized. Key concepts: uncovered interest parity (UIP), expected exchange rate changes, and portfolio substitution between domestic and foreign assets.

Step-by-step reasoning:
1. Write the expected return on a foreign bond measured in domestic currency: i_foreign + expected percentage change in the exchange rate (E^e - E)/E. For small changes approximate return = i_f + expected depreciation/appreciation of the domestic currency relative to the foreign currency.
2. Arbitrage/indifference condition implies: i_dom ≈ i_for + expected change in exchange rate. If domestic interest rates are higher, domestic assets are more attractive unless the domestic currency is expected to depreciate enough to offset the higher yield.
3. Numerical illustration: if i_dom = 5% and i_for = 2%, investors will be indifferent only if the domestic currency is expected to depreciate by about 3% (2% + 3% = 5%). If expected depreciation is less, capital flows into domestic assets and the domestic currency appreciates until equilibrium.

Why the correct option is correct:
- The first choice precisely states the central mechanism: relative interest rates together with expectations of currency strengthening/weakening determine demand for domestic versus foreign financial assets, which is the core of the asset market approach.

Why the other choices are incorrect:
- “All of these” is wrong because not all subsequent statements are true descriptions of this approach.
- “It explains appreciations and depreciations in the long run” is misleading: the asset market approach is primarily about short- to medium-term movements driven by portfolio shifts and expectations, not long-run real adjustments (which other theories address).
- “It is based on changes in demand for domestic versus foreign goods and services” is incorrect: that describes the goods market/relative demand approach (trade balance), not the asset/financial assets perspective.

Conclusion: The correct answer is the first option: it says relative rates of interest and expected strengthening/weakening of currencies determine demand for domestic versus foreign financial assets. This matches the provided answer.

Which is true about the asset market approach?单项选择题

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