A Multi-Polar rather than a Bi-Polar Investment World

The results we have looked at so far with regard to this model assume a bi-polar world of money/cash or interest-bearing securities. Suppose however that our investment world is much more complex than that, involving equities, fixed income securities, money market funds and money/cash. As a central bank cuts interest rates, the effect of this should be spread across these asset classes, which in turn react in different ways. If a central bank cuts interest rates, this should cause the investor to cut their portfolio weighting in money market funds and increase it in equities. In the short term, it should also cause an increase in the weighting for fixed income securities as the capital gain should offset the lost income. Eventually, however, we should assume that it causes a reduction in the weighting for fixed income securities. Finally, a rate cut should also lead to an increase in the weighting of money/cash. The reduction in money market funds and fixed income securities should logically equal the sum of the increase in weighting in equities and money/cash. Since money/cash has to share its gains with equities, one should assume that the effect on money demand and therefore prices is reduced. Prices should rise less than they would otherwise do without the influence of equities. Consequently, as prices rise by less, the exchange rate should also depreciate by less than one would otherwise expect. In the same way, an interest rate increase should in this multi-polar investment world lead to less of an exchange rate appreciation than would be expected in a bi-polar investment world.