A nation’s
balance of payments is a complex set of accounts. There are three major
accounts involved:
·
Current
Account (aka Trade Account): Imports and exports of goods and services.
·
Capital
Account: Records all trades which affect the amount of claims the nation has
abroad, both for and against. Or in other words, all borrowing and lending
activity.
·
Official
Settlements Account: Records the changes in currency reserves held in all
foreign currencies.
These three
accounts sum to zero. The total import and export activity, plus the net effect
of borrowing and lending, must equal the change in currency reserves. The term
“balance of trade deficit” refers to the current account, and the term “balance
of payments defecit” refers to the capital account. A balance of payments
defecit can be thought of as the excess supply of a country’s currency—this is
the amount of foreign currency that the government must buy if the exchange
rate is to be preserved. If the government does not act, a defecit in this
account will result in a currency devaluation.
The total
value of world trade is more than 3 trillion dollars a year, but this is a
small amount compared to the total value of worldwide currency trading. If
currencly fluctuations only occurred as a result of trade, currencies would be
quite stable. However, currencies are not stable, because fluctuations also
occur due to currency trading that has nothing to do with goods or services
trading. For example, if our interest rates are higher than another nation’s,
then citizens (and fund managers) in the other nation can improve their returns
by buying our currency. Expectations about the future appreciation or
depreciation of our currency will also make it more or less attractive to buy.
As a result, it is very difficult to predict how exchange rates will change
with time. Note that the supply of our currency will affect these expectations
and so the supply and demand of our currency are not entirely independent.