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Balance of Payments Model

Balance of Payments Model
Published:   12 Dec at 9 AM

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This model holds that a foreign exchange
rate must be at its equilibrium level - the rate which produces a stable
current account balance. A nation with a trade deficit will experience
reduction in its foreign exchange reserves which ultimately lowers (depreciates)
the value of its currency. The cheaper currency renders the nation's
goods (exports) more affordable in the global market place while making
imports more expensive. After an intermediate period, imports are forced
down and exports rise, thus stabilizing the trade balance and the currency
towards equilibrium.

Like Purchasing Power Parity, the
balance of payments model focuses largely on trade-able goods and services,
ignoring the increasing role of global capital flows. In other words,
money is not only chasing goods and services, but to a larger extent,
financial assets such as stocks and bonds. Their flows go into the capital
account item of the balance of payments, thus, balancing the deficit
in the current account. The increase in capital flows has given rise
to the asset market model.

A balance of payments (BOP) sheet
is an accounting record of all monetary transactions between a country
and the rest of the world.These transactions include payments for the
country's exports and imports of goods, services, and financial capital,
as well as financial transfers. The BOP summarises international transactions
for a specific period, usually a year, and is prepared in a single currency,
typically the domestic currency for the country concerned. Sources of
funds for a nation, such as exports or the receipts of loans and investments,
are recorded as positive or surplus items. Uses of funds, such as for
imports or to invest in foreign countries, are recorded as a negative
or deficit item.

When all components of the BOP sheet
are included it must balance – that is, it must sum to zero –
there can be no overall surplus or deficit. For example, if a country
is importing more than it exports, its trade balance will be in deficit,
but the shortfall will have to be counter balanced in other ways –
such as by funds earned from its foreign investments, by running down
reserves or by receiving loans from other countries.

While the overall BOP sheet will
always balance when all types of payments are included, imbalances are
possible on individual elements of the BOP, such as the current account.
This can result in surplus countries accumulating hoards of wealth,
while deficit nations become increasingly indebted. Historically there
have been different approaches to the question of how to correct imbalances
and debate on whether they are something governments should be concerned
about. With record imbalances held up as one of the contributing factors
to the financial crisis over the past three years, plans to address
global imbalances are now high on the agenda of policy makers for 2010.

A balance-of-payments crisis, also
known as a currency crisis, is a speculative attack in the foreign exchange
market. It occurs when the value of a currency changes quickly, undermining
its ability to serve as a medium of exchange or a store of value. It
is a type of financial crisis and is often associated with a real economic
crisis. Currency crises can be especially destructive to small open
economies or bigger, but not sufficiently stable ones. Governments often
take on the role of fending off such attacks by satisfying the excess
demand for a given currency using the country's own currency reserves
or its foreign reserves (usually in the United States dollars, Euro
or Pound sterling).

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