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This paper proposes an equilibrium theory of nominal exchange rates, asset flows and country portfolios which offers a new perspective
to several issues in open economy macroeconomics.
The nominal exchange rate and portfolio choices are jointly determined in equilibrium,
which provides a new approach to overcome the indeterminacy results in Kareken & Wallace (1981).
The determinants of the nominal exchange rate are the amount of assets issued by a country in its currency, the net foreign asset position, the nominal interest rate and productivity and show that changes in each of the determinants lead to depreciations or appreciations in line with empirical evidence.
The novel theory also offers a different perspective on how international asset flows affect exchange rates, how a country can divorce itself from these flows and how a country can manage its exchange rate. The model also implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma as it not only loses monetary
but also fiscal policy independence. This suggest a new way to think about fiscal coordination in a monetary union as a response to within union asset flows.
