Balance Of Payments Model

This model holds that a foreign exchange rate must be at its equilibrium level, i.e. the rate that produces a stable current account balance. For example, a nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's exports more affordable in the global marketplace 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, while 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.

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