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1 Asset Market Model on 30th September 2013, 1:57 pm


This model is similar to the balance of payments model, but instead of taking into account the balance of payments it focuses primarily on the current account. In order to understand both models, let's lay out some basic definitions:
The international balance of payments accounts for all the international economic transactions between individuals, businesses and government agencies in the domestic economy with the rest of the world. Every international transaction involving different currencies results in a credit and a debit in the balance of payments.
Credits are transactions that increase the amount of money to domestic residents from foreigners, and debits are transactions that increase the money paid to foreigners. For instance, if a company in Brazil buys Spanish machinery, the purchase is a debit to the Brazilian account and a credit to the Spanish account.
The balance of payments account is divided in two main accounts: the current account and the capital account. The current account consists of international trade in goods and services and earnings on investments. In other words, it is the sum of the balance of trade (exports minus imports of goods and services), net income receipts (such as interest and dividends derived from the ownership of assets) and net unilateral transfer payments (such as direct foreign aid, worker remittances from abroad, etc.).
The capital account consists of capital transfers (including debt forgiveness and migrant's transfers, among others) and the acquisition and disposal of non-produced and non-financial assets (representing the sales and purchases of non-produced assets such as franchises, copyrights, etc.).
A subdivision of the capital account, the financial account, records transfers which involve financial capital. It is the net result of public and private international investment flowing in and out of a country. This includes foreign-owned investment in the domestic economy (government and corporate securities, direct investment, domestic currency, etc.), and domestic-owned assets abroad (official reserve assets, government assets, and private assets).
The official reserves account, which is a part of the financial account, is the foreign currency held by central banks, and it is used to compensate deficits in the balance of payment. When there is a trade surplus, the official reserves increase. Conversely, it decreases when there is a deficit.
This model strives to attain the equilibrium - a condition where the sum of debits and credits of the current account and the capital and financial accounts equal to zero. Under a balanced condition, the value of the domestic currency should also be at its equilibrium level. However, practical evidence shows that it deviates from equilibrium.
Let's take the example of the US and its trade deficit. We know that a country with a persistent current account deficit is importing more goods and services than selling. In the balance of payments, this appears as an inflow of foreign capital. Therefore, under this model, the US should finance the difference by borrowing or selling more capital assets, that is, creating a capital account surplus to compensate the current account deficit. In fact both accounts do not exactly offset each other because of statistical discrepancies in the model and exchange rate movements that modify the value of the recorded international transactions. But the main limitation to the model is that no direct correlation has been proved between the value of a nation's currency and the imbalance between the nation's capital account and current account.
The asset model approach considers currencies as being asset prices traded in an efficient financial market and consequently demonstrating a strong correlation with other markets, particularly equities. This is not always the case as many empirical studies evidence. Over the long run, it seems there is no

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