The Market Balance
The accounting balance can be a rather powerful instrument for ex post description of events.
But it is not a very strong instrument for ex ante analysis of events. Being essentially a classificatory device, the accounting balance can do little more than indicate, in an approximate fashion, the extent of balance or imbalance of past transactions.
But what governments most need to know for policy purposes, and in as precise a fashion as possible, is the extent of balance of equilibrium or disequilibrium of autonomous, intended transactions.
For these purposes, the accounting balance is inconvenient and cumbersome. Of much more interest is the main alternative concept of the balance of payments--- the market balance.
The market balance of payments can best be understood as a model of a given situation in the foreign exchange market, distinguished by the competent demand and supply.
This is marked by the effective demand and supply for foreign exchange at the existing exchange rate and at alternative, assumed rates.
By definition, it is an ex ante concept, comparing autonomous spending and receipts given present and expected future incomes, prices, interest rates, tastes, and so forth.
We thus return to the interaction of demand and supply in the foreign exchange market. In fact, the interaction of demand and supply in the foreign exchange market is what the balance of payments is all about.
When demand for foreign exchange is just equal to supply at a given exchange rate, the implication is that autonomous transactions requiring foreign money payments are just equal to autonomous transactions involving foreign money receipts.
The balance of payments is in equilibrium, and no problem of adjustment arises. On the other hand, when demand and supply are not equal, the implication is that auto money payments and receipts must be out of line, and the balance of payments is in disequilibrium.
At that point, a problem of adjustment arises. The essence of the problem of adjustment is to reconcile any such differences between autonomous demand and supply of foreign exchange at some rate of exchange.
However, in the process of payments adjustment--- there are in two 'pure' mechanisms of adjustment to a disequilibrium in the balance of payments. Assume an excess of demand of supply in the foreign exchange market (an excess of autonomous money payment over money receipts).
If the exchange rate is free to move (rates are 'floating' or 'flexible'), the price of foreign currencies will immediately be bid up and domestic money will decline in value.
In the domestic economy, prices of tradable goods, services, and assets will rise to prices of nontradables, and the gap between autonomous demand and supply of foreign exchange will be closed by movements along the existing schedules to the point where they intersect.
Alternatively, if the exchange rate is not free to move (rates are 'fixed' or 'pegged'), the deficit in the balance of payments gradually will reduce the net foreign liquidity of the country, siphoning off internal purchasing power as domestic money is sold for foreign currencies.
The money will be withdrawn from circulation, and domestic incomes and prices will decline, eventually contracting the country's autonomous demand for foreign exchange and possibly also expanding the supply.
The gap between the two schedules will be closed as both of them shift until they intersect at the prevailing rate of exchange.