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1 International Balance of Payments Model on 30th September 2013, 1:56 pm

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Until the 90's the balance of payments theory focused primarily on the balance of trade, a sub account of the current account. This was due to the fact that capital flows were not as significant as nowadays and the trade balance made up the major part of the balance of payments for most world economies.
Under this model, a nation with a trade deficit will experience a reduction of its foreign exchange reserves it used to pay for the imported goods. A country has to change its own currency for the exporters currency to pay for the goods - this makes its own currency depreciate.
In turn, a cheaper currency makes the nation's exported goods and services less expensive in the global market place while making imports more expensive. The simplified balance of payments model states that after an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Based on this model, many analysts forecast that the USD would fall in value against other major currencies, specially the Euro, due to the expanding US trade deficit. But in reality, international capital flows in the last decade have been characterized by global investors acquiring billions of assets in the US, yielding a net capital account surplus. This surplus, despite of statistical discrepancies and currency fluctuations, balanced the current account deficit.
Since the balance of payments is not only made up of the trade balance - it is largely made up of the current account balance - this model failed to accurately forecast exchange rate moves. The balance of payments model focuses largely on trade, while ignoring the increasing role of international capital flows such as foreign direct investment, bank loans and, more importantly, portfolio investments. These capital flows go into the capital account item of the balance of payments, and in some occasions a positive capital flow balances a deficit in the current account.
The explosion of capital flows and the trading of financial assets have given rise to the asset market model. The new reality has reshaped the way analysts and traders look at currencies as flows of funds into financial assets increase the demand for the currency they are denominated in. Conversely, a flow out of a countries' financial assets, such as equities and bonds, produces a decrease in the demand for its currency.


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