Foundation of International Finance

6/11/2021
Foundation of International finance

• International finance is an area of financial economics that
deals with monetary interactions between two or more
countries
• concerning itself with the topics such as currency
exchange rates, international monetary system, FDI
including risk
• it helps multinational corporations in dealing with cross
Prepared by: Nguyen Thi Xuan Lan, PhD. border transactions by detailing various financial aspects
involved to these transactions.
INTERNATIONAL TRADE
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Foundation of International finance Why international trade developed

• The emergence and rise of multinational companies has • Comparative advantage
resulted in high levels of international business activities.
International business encompasses commercial • Source of comparative advantage
transactions like sales, investment and transportation
• Gainers and losers
between two or more companies.
• These cross border flows has resulted in world economy. • Commercial policy
Due to this there is a need to manage the international
finance
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• Comparative advantage Gainers and losers

• Trade offers benefits when there are
• Countries may gain from specialisation
international differences in the opportunity cost and trade
of goods.
• but not all countries may gain equally
• Opportunity cost of a good
• the quantity of other goods sacrificed to make one
more unit of that good
• The law of comparative advantage
• states that countries should specialise in producing
and exporting the goods that they produce at a lower
relative cost than other countries.
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Source of comparative advantage Commercial policy

• An important difference between countries is in factor
• is government policy that influences
endowments international trade through taxes or subsidies
• which will be reflected in different relative factor prices
• e.g. tariffs
• e.g. if the UK has relatively abundant capital but relatively scarce
labour as compared with India,
• or through direct restrictions on imports and
• then the UK would tend to specialise in capital-intensive goods,
exports.
• and India would tend to specialise in labour-intensive products
• Comparative advantage may also reflect a relative

advantage in technology
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The economic effects of a tariff Tariffs

DD and SS show the domestic
SS demand and supply for a good. • The deadweight burden of a tariff suggests
If the world price is Pw, that society suffers from this method of
and there is free trade,
restricting trade.
Pw + T
domestic firms supply Qs
domestic demand is Qd • This is the case for free trade.
Pw and the difference is imported.
DD • Tariffs have fallen substantially under the
A tariff can stimulate domestic
Q s Q s' Qd' Qd Quantity
supply and restrict imports. GATT
At a domestic price Pw + T, • General Agreement on Tariffs and Trade
where T is the size of the tariff.
Domestic demand falls to Qd', domestic supply rises to Qs'
and imports fall.
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The welfare costs of a tariff The case for tariffs – good arguments
SS The tariff leads both to • Optimal tariff

transfers and net social
• a first-best argument
losses.
• only valid where the importing country is large enough to
The government raises affect the world price.
revenue – i.e. there is a • This policy fulfils the principle of targeting
Pw + T transfer to the government
• which says that the most efficient way to attain a given
Pw and there is a transfer in objective is to use a policy that influences that activity
DD the form of extra profits to directly.
producers. • Policies that attain the objective, but also influence other
Q s Q s' Qd' Qd Quantity activities are second-best, because they distort those
other activities.
There is a social cost from production inefficiency, given that the
good could be imported at Pw, and a loss of consumer surplus.
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The case for tariffs – second-best arguments An export subsidy

• Way of life
• an attempt to preserve ‘traditional’ ways Under free trade, with the
• a production subsidy would be better world price at Pw,
• Suppressing luxuries
• an attempt to curb consumption patterns of the rich in a poor society S consumers demand Qd
• better achieved by a consumption tax production is Qs
A B
• Infant industries Pw+ s exports are GE.
• an attempt to nurture new activities via learning by doing G E Subsidy
• a temporary production subsidy probably better Pw World
With a subsidy, producers
• Revenue
produce Qs’ and supply Qd' to
price
the domestic market.
• tariffs raise government revenue
Price
• but there are better ways Exports now rise to AB.
• Cheap foreign labour Social costs arise from
• a non-argument – denies benefits of comparative advantage DD production inefficiency
Qd' Qd Qs Q`s' and the loss of consumer surplus.
Quantity
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Other commercial policies Foreign exchange markets

• It is the market in which currencies are bought &
• Although tariff rates have fallen under GATT, there has
sold against each other.
been a proliferation of other trade restrictions
• quotas
• No single physical location.
• non-tariff barriers • A world wide network of primarily banks
• administrative regulations that discriminate against foreign goods connected through a telecommunication network.
• export subsidies
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Foreign exchange markets Foreign exchange markets
• Appreciation: a currency rises in value relative to another

currency
• Depreciation: a currency falls in value relative to another
currency
• When a country’s currency appreciates, the country’s goods
Spot Forward abroad become more expensive and foreign goods in that
Derivatives country become less expensive and vice versa
transactions transactions
• Over-the-counter market mainly banks
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Figure 1 Exchange Rates, 1990–2011

Foreign exchange markets
• Exchange rate: price of one currency in terms of another
• Foreign exchange market: the financial market where
exchange rates are determined
• Spot transaction: immediate (two-day) exchange of bank
deposits
• Spot exchange rate
• Forward transaction: the exchange of bank deposits at
some specified future date
• Forward exchange rate
Source: Federal Reserve; www.federalreserve.gov/releases/h10/hist.
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Exchange Rates in the Long Run Factors that Affect Exchange Rates in
the Long Run
• Law of one price
• Relative price levels
• Theory of Purchasing Power Parity assumptions:
• All goods are identical in both countries • Trade barriers
• Trade barriers and transportation costs are low • Preferences for domestic versus foreign goods
• Many goods and services are not traded across borders
• Productivity
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Figure 2 Purchasing Power Parity, United States/United Summary Table 1 Factors That Affect Exchange
Kingdom, 1973–2011 (Index: March 1973 = 100.) Rates in the Long Run
Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt.
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Exchange Rates in the Short Run: A Supply Explaining Changes in Exchange Rates
and Demand Analysis
• An exchange rate is the price of domestic assets in terms of • Shifts in the demand for domestic assets
foreign assets • Domestic interest rate
• Supply curve for domestic assets
• Foreign interest rate
• Assume amount of domestic assets is fixed (supply curve is vertical)
• Expected future exchange rate
• Demand curve for domestic assets
• Most important determinant is the relative expected return of domestic
assets
• At lower current values of the dollar (everything else equal), the
quantity demanded of dollar assets is higher
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Figure 3 Equilibrium in the Foreign Figure 4 Response to an Increase in the Domestic

Exchange Market Interest Rate, iD
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Figure 5 Response to an Increase in the Foreign

Interest Rate, iF
Summary Table 2
Factors That Shift the
Demand Curve for
Domestic Assets and
Affect the Exchange
Rate
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Figure 6 Response to an Increase in the Expected APPLICATION Effects of Changes in Interest Rates
Future Exchange Rate, Eet+1 on the Equilibrium Exchange Rate
• Changes in Interest Rates
• When domestic real interest rates raise, the domestic currency
appreciates.
• When domestic interest rates rise due to an expected increase in
inflation, the domestic currency depreciates.
• Changes in the Money Supply
• A higher domestic money supply causes the domestic currency to
depreciate.
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Figure 7 Effect of a Rise in the Domestic Interest Rate

as a Result of an Increase in Expected Inflation Figure 8 Value of the Dollar and Interest Rates, 1973–2010
Sources: Federal Reserve; www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in

Chapter 4.
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Application: The Dollar and Interest Rates Application: The Global Financial Crisis and
the Dollar
• The value of the dollar and the measure of real interest
rates tend to rise and fall together • During 2007 interest rates fell in the United States and
remained unchanged in Europe.
• The dollar depreciated
• Our model of exchange rate determination helps • Starting in the summer of 2008 interest rated fell in Europe.
explain the rise in the dollar in the early 1980s and fall
• Increased demand for U.S. Treasuries “flight to quality”
thereafter • The dollar appreciated
• a rise in the U.S. real interest rate raises the relative expected
return on dollar assets, which leads to purchases of dollar
assets that raise the exchange rate
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Expanding technical infrastructure Balance of payments

 Online transaction • Structure of the BOP:
 New technology The BOP consists of the current account and the
 Awareness about services offered in other financial account.
countries
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Balance of payments Balance of payments

Definition • Current Account • Capital Account
• International transactions that • Net receipts from capital
• The balance of payments (BOP) is a systematic record of
involve currently produced transactions
all economic transactions between the residents of the goods and services
reporting country and the rest of the world over a specified • Trade Balance
period of time.
Important Elements in the Definition
• Rest of the world
• Economic transactions •Sum of these two is the official reserve transactions
• Resident balance
• Flows versus stocks
• The BOP records changes in assets and liabilities.
• Figures may or may not be seasonably adjusted.
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Components of the Current Account

• Merchandise account (trade balance)
• Net services INTERNATIONAL MONETARY SYSTEM
• Current transfers
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The Financial Account INTERNATIONAL MONETARY SYSTEM

• Records official and non-official net financial flows. Definition
• A balancing item is added to account for errors and The IMS refers to the framework of rules, regulations and
omissions. conventions that govern the financial relations among
countries.
Components of the IMS
• Public component consisting of a series of agreements
• Private component represented by the banking and
finance industry
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Intervention in the Foreign Exchange
Market (cont’d)
Classification
Classification According to Reverse Assets :
• Unsterilized foreign exchange intervention:
• Pure commodity standards (e.g. the gold standard)
– An unsterilized intervention in which domestic currency
is sold to purchase foreign assets leads to a gain in
• Pure fiat standards
international reserves, an increase in the money supply,
• Mixed standards (e.g. the Bretton Woods system) and a depreciation of the domestic currency
Classification According to Flexibility of Exchange

Rates
• Several systems may arise by restricting, or otherwise,
the exchange rate.
18-47 © 2013 Pearson Education, Inc. All rights reserved.
Intervention in the Foreign Exchange Figure 1 Effect of an Unsterilized Purchase

Market of Dollars and Sale of Foreign Assets
•Foreign exchange intervention and the money supply
Federal Reserve System Federal Reserve System

Assets Liabilities Assets Liabilities
Foreign -$1B Currency in -$1B Foreign -$1B Deposits -$1B
Assets circulation Assets with the Fed
(International (International (reserves)
Reserves) Reserves)
• A central bank’s purchase of domestic currency and corresponding sale of

foreign assets in the foreign exchange market leads to an equal decline in
its international reserves and the monetary base
• A central bank’s sale of domestic currency to purchase foreign assets in
the foreign exchange market results in an equal rise in its international
reserves and the monetary base
18-46 © 2013 Pearson Education, Inc. All rights reserved. 18-48 © 2013 Pearson Education, Inc. All rights reserved.
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Intervention in the Foreign Exchange Exchange Rate Regimes in the International

Market (cont’d) Financial System (cont’d)
•Sterilized foreign exchange intervention • Gold standard

Federal Reserve System – Fixed exchange rates
Assets Liabilities – No control over monetary policy
Foreign Assets Monetary Base – Influenced heavily by production of gold and
(International Reserves) -$1B (reserves) 0 gold discoveries
Government Bonds +$1B
• Bretton Woods System
• To counter the effect of the foreign exchange – Fixed exchange rates using U.S. dollar as reserve
intervention, conduct an offsetting open market currency
operation
– International Monetary Fund (IMF)
• There is no effect on the monetary base and no effect
on the exchange rate
Exchange Rate Regimes in the Exchange Rate Regimes in the International

International Financial System Financial System (cont’d)
• Fixed exchange rate regime • Bretton Woods System (cont’d)

– World Bank
– Value of a currency is pegged relative to the value of – General Agreement on Tariffs and Trade (GATT)
one other currency (anchor currency) • World Trade Organization
• Floating exchange rate regime • European Monetary System

– Value of a currency is allowed to fluctuate against all – Exchange rate mechanism
other currencies
• Managed float regime (dirty float)
– Attempt to influence exchange rates by buying and
selling currencies
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How a Fixed Exchange Rate

Regime Works Figure 3 The Policy Trilemma
• When the domestic currency is overvalued, the central

bank must
– purchase domestic currency to keep the exchange rate fixed (it
loses international reserves), or
– conduct a devaluation
• When the domestic currency is undervalued, the central
bank must
– sell domestic currency to keep the exchange rate fixed (it gains
international reserves), or
– conduct a revaluation
Figure 2 Intervention in the Foreign How the Bretton Woods System

Exchange Market Under a Fixed Exchange Worked
Rate Regime
• Exchange rates adjusted only when experiencing a
‘fundamental disequilibrium’ (large persistent deficits in
balance of payments)
• Loans from IMF to cover loss in international reserves
• IMF encouraged contractionary monetary policies
• Devaluation only if IMF loans were not sufficient
• No tools for surplus countries
• U.S. could not devalue currency
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Figure 4 Foreign Exchange Market for

Managed Float
British Pounds in 1992
• Hybrid of fixed and flexible

– Small daily changes in response to market
– Interventions to prevent large fluctuations
• Appreciation hurts exporters and employment
• Depreciation hurts imports and stimulates inflation
• Special drawing rights as substitute for gold
European Monetary System (EMS) Capital Controls
• 8 members of EEC fixed exchange rates with one • Controls on outflows

another and floated against the U.S. dollar – Promote financial instability by forcing a devaluation
• ECU value was tied to a basket of specified – Controls are seldom effective and may increase capital
flight
amounts of European currencies
– Lead to corruption
• Fluctuated within limits – Lose opportunity to improve the economy
• Led to foreign exchange crises involving • Controls on inflows
speculative attack – Lead to a lending boom and excessive risk taking by
financial intermediaries
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Capital Controls (cont’d) How Should the IMF Operate?
• Controls on inflows (cont’d) • May not be tough enough

– Controls may block funds for productions uses
• Austerity programs focus on tight macroeconomic
– Produce substantial distortion and misallocation
– Lead to corruption policies rather than financial reform
• Strong case for improving bank regulation • Too slow, which worsens crisis and increases
and supervision costs
• Countries were restricting borrowing from the IMF
until the recent subprime financial crisis
GLOBAL The Global Financial Crisis and the

The Role of the IMF IMF
• Emerging market countries with poor central bank • When the global financial crisis became more virulent in
credibility and short-run debt contracts October 2008, a number of emerging market countries, as
well as Iceland and former communist countries, found that
denominated in foreign currencies have limited
foreigners were pulling funds out of their financial systems
ability to engage in this function
• May be able to prevent contagion • The IMF created a new lending program at the end of
October 2008, called the Short-Term Liquidity Facility, with
• The safety net may lead to excessive risk taking
$100 billion of funds to distribute loans where needed
(moral hazard problem)
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International Considerations and To Peg or Not to Peg: Exchange-Rate

Monetary Policy Targeting as an Alternative Monetary Policy
Strategy
• Balance of payment considerations:
• Advantages of Exchange-Rate Targeting:
– Current account deficits in the U.S. suggest that
American businesses may be losing ability to compete – Contributes to keeping inflation under control
because the dollar is too strong – Automatic rule for conduct of monetary policy
– U.S. deficits mean surpluses in other countries large – Simplicity and clarity
increases in their international reserve holdings
world inflation
To Peg or Not to Peg: Exchange-Rate

International Considerations and Targeting as an Alternative Monetary Policy
Monetary Policy (cont’d) Strategy (cont’d)
• Exchange rate considerations: • Disadvantages of exchange-rate targeting:
– A contractionary monetary policy will raise the domestic – Cannot respond to domestic shocks and shocks to
interest rate and strengthen the currency anchor country are transmitted
– An expansionary monetary policy will lower interest – Open to speculative attacks on currency
rates and weaken currency – Weakens the accountability of policymakers as the
exchange rate loses value as signal
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When Is Exchange-Rate Targeting Desirable

for Industrialized Countries?
Currency Boards
• Exchange-rate targeting for industrialized • Solution to lack of transparency and commitment

countries is desirable if: to target
– Domestic monetary and political institutions are not • Domestic currency is backed 100% by a foreign
conducive to good policy making currency
– Other important benefits such as integration arise from • Note issuing authority establishes a fixed
this strategy
exchange rate and stands ready to exchange
currency at this rate
• Money supply can expand only when foreign
currency is exchanged for domestic currency
When Is Exchange-Rate Targeting Desirable Currency Boards (cont’d)

for Emerging Market Countries?
• Exchange-rate targeting for emerging market • Stronger commitment by central bank

countries is desirable if: • Loss of independent monetary policy and increased
exposure to shock from anchor country
– Political and monetary institutions are weak (strategy
becomes the stabilization policy of last resort). • Loss of ability to create money and act as lender of last
resort
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New International Financial

Dollarization
Architecture
• Another solution to lack of transparency • Linking IMF loans to crisis prevention efforts
and commitment • Imposition of holding-period taxes on short-term
• Adoption of another country’s money capital flows in countries characterised by financial
• Even stronger commitment mechanism fragility
• Completely avoids possibility of speculative attack • Making the private sector partly responsible for the
on domestic currency consequences of sovereign bond issues
• Lost of independent monetary policy and • Discouraging fixed but adjustable exchange rates
increased exposure to shocks from anchor country in favour of either managed floating or currency
boards
New International Financial

Dollarization (cont’d)
Architecture (cont.)
• Inability to create money and act as lender of last resort • Directing the IMF to lend less freely and to
• Loss of seignorage distinguish between country crises and systemic
crises
• Removing overlap from the responsibilities of the
IMF and the World Bank
19

Foundation of International Finance

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6/11/2021

Foundation of International finance

Foundation of International finance Why international trade developed

• Comparative advantage Gainers and losers

Source of comparative advantage Commercial policy

• Comparative advantage may also reflect a relative

The economic effects of a tariff Tariffs

SS The tariff leads both to • Optimal tariff

The case for tariffs – second-best arguments An export subsidy

Other commercial policies Foreign exchange markets

Foreign exchange markets Foreign exchange markets

• Appreciation: a currency rises in value relative to another

Figure 1 Exchange Rates, 1990–2011

Source: Federal Reserve; www.federalreserve.gov/releases/h10/hist.

Figure 3 Equilibrium in the Foreign Figure 4 Response to an Increase in the Domestic

Figure 5 Response to an Increase in the Foreign

Figure 7 Effect of a Rise in the Domestic Interest Rate

Sources: Federal Reserve; www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in

Expanding technical infrastructure Balance of payments

Balance of payments Balance of payments

Components of the Current Account

The Financial Account INTERNATIONAL MONETARY SYSTEM

Classification According to Flexibility of Exchange

18-47 © 2013 Pearson Education, Inc. All rights reserved.

Intervention in the Foreign Exchange Figure 1 Effect of an Unsterilized Purchase

Federal Reserve System Federal Reserve System

• A central bank’s purchase of domestic currency and corresponding sale of

Intervention in the Foreign Exchange Exchange Rate Regimes in the International

•Sterilized foreign exchange intervention • Gold standard

Exchange Rate Regimes in the Exchange Rate Regimes in the International

• Fixed exchange rate regime • Bretton Woods System (cont’d)

• Floating exchange rate regime • European Monetary System

How a Fixed Exchange Rate

• When the domestic currency is overvalued, the central

Figure 2 Intervention in the Foreign How the Bretton Woods System

Figure 4 Foreign Exchange Market for

• Hybrid of fixed and flexible

European Monetary System (EMS) Capital Controls

• 8 members of EEC fixed exchange rates with one • Controls on outflows

Capital Controls (cont’d) How Should the IMF Operate?

• Controls on inflows (cont’d) • May not be tough enough

GLOBAL The Global Financial Crisis and the

International Considerations and To Peg or Not to Peg: Exchange-Rate

To Peg or Not to Peg: Exchange-Rate

When Is Exchange-Rate Targeting Desirable

• Exchange-rate targeting for industrialized • Solution to lack of transparency and commitment

When Is Exchange-Rate Targeting Desirable Currency Boards (cont’d)

• Exchange-rate targeting for emerging market • Stronger commitment by central bank

New International Financial

New International Financial

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