Capital Flows
Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the firms exchange euros for pesos.
In general, there are two reasons for demanding a country's currency: to purchase assets within the country and to purchase a country's exports - that is, the goods and services produced within that country. The country's currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or services from other countries.
Imaging that we are analyzing Italy's economy and its currency transactions with the rest of the world. If an American buyer wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets. Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country's currency.
Likewise, a country's currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for eample, are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied when Italian purchasers acquire assets from other countries.
Equilibrium and Zero Balance
When a country's balance of payments is equal to zero, there is equilibrium in the market for that country's currency. Equilibrium occurs when:
Quantity of currency demanded = quantity of currency supplied
We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets. The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can rewrite the relationship:
Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)
Finally, we can rearrange the above formula as:
Exports - imports = (domestic purchases of foreign assets) - (foreign purchases of domestic assets)
The left-hand term is net exports - the difference between the amount of goods and services a country exports and the amount that it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is positive and we say that the country has a current accounts surplus. When a country imports more than it exports this number is negative and we say that the country has a current accounts deficit.
The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive and there is a financial account surplus.
If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa. This holds true when a country's currency market is in equilibrium and there are no external currency controls.
Exchange Rates
Exchange rates are constantly fluctuating to ensure that the quantity of currency supplied equals the quantity demanded. Because of this, the inflows and outflows of money are equal, creating a balance of payments equal to zero.