balance of payments model

Let’s introduce some forex information. 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 lower (depreciate) 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 PPP, the balance of payments model focuses largely on tradable 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 large 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.