1

International FinanceLecture 1

2

ECONOMICS

Macroeconomics

Macroeconomics

Microeconomics

International Finance:

International Trade

Monetary Theories

Exchange Rates

Economic variables: GDP, Price Level, Interest Rates

3

Learning Outcomes

What is international finance concerned with? Gains from the trade for a nation. The balance of payments. Currencies and Exchange Rates. Model of Economies. Cyprus and Uk Economy.

4

What is International Finance? International Finance, also referred to as international

economics, is about how nations interact through trade of goods and services, through flows of money and through investment.

At the beginning of the 21st century, nations are more closely linked through

trade in goods and services, through flows of money, and through investment in each others’economies than ever before.

International Finance is also concerned with matters of

Monetary Policy, Fiscal Policy and foreign exchange rates.

Figure 1.1 shows International trade as a portion of the national economy has tripled for the US in the past 40 years.

5

6

Figure 1-2: Exports and Imports as Percentages of National Income in 1994. Compared to the US, other countries are

even more tied to international trade.Why?

7

The U.S due to its size and extent of resources relies

less on international trade than almost any other country.

Consequently for the rest of the world International

Finance is even more important than it is for the United

States.

Validation:

8

Trade is occurred for physical industrial products and

also for services such as restaurants, hotels, transport,

storage,communications,financial services, insurance,

real estate, business services, personal services,

community services,social services and government

services.e.g. maintenance services from abroad, or architectural services from a

foreigner professional, educational services e.t.c

World Trade in Services

9

The relative size of trade is often measured by comparing the size of a country’s exports with its gross domestic product Exports

GDP The nature of ‘services’ is such that it is extremely

difficult to obtain accurate estimation of the value of these transactions. This results form the fact that there is no agreed definition of what composes a traded service, and the ways in which these transactions are measured are less accurate than is the case of retail trade.

How does trade is being measured?

10

GAINS FROM THE TRADE:Several ideas underlie the gains from trade:

1.When a buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off.

–Norwegian consumers could buy oranges through international trade that they otherwise would have a difficult time producing.

–The producer of the oranges, on the other hand, receives income that it can use to buy the things that it desires.

11

2.How could a country that is the most or the least efficient producer of everything gain from trade?

– Countries can use those resources to produce what they are most productive at ,compared to their other production choices, then trade those products for goods and services that they want to consume. Therefore they can specialize in production. According to Adam Smith a country should specialize and export those goods in which it has an absolute advantage – where absolute labor required is less than that of the possible trading partner – and should import those goods in which the trading partner had an absolute advantage.

Absolute Advantage: Where one country can produce goods with fewer resources than another

Comparative Advantage: Where one country can produce goods at a lower opportunity cost – which mean that it sacrifices less resources in production

12

One of the most important sources of error when discussing international trade is to confuse absolute advantage with comparative advantage. Absolute advantage: is when a country can produce a unit of

good with less labor than another country

unit of labor= the number of hours of labor required to produce

one unit of product (e.g. a kilo of cheese).

Comparative advantage: Economists use the word opportunity cost to describe this concept. For e.g. the opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used to produce a given number of roses.

13

Comparative AdvantageOil (Barrels) Whisky (Litres)

Russia 10 or 5

Scotland 20 or 40

One unit of labour in each country can produce either oil OR whisky.A unit of labour in Russia can produce either 10 barrels of oil per period OR 5 litres of whisky.A unit of labour in Scotland can produce either 20 barrels of oil OR 40 litres of whisky.

14

Comparative AdvantageDefinition: Opportunity Cost = sacrifice/ gain

The decision to produce a product required giving up another product

Russia: if it moved 1 unit of labour from whisky to oil it would sacrifice 5 litres of whisky but gain 10 barrels of oil (OC of oil= 5/10 = ½)

Moving 1 unit of labour from oil to whisky production would lead to a sacrifice of 10 barrels of oil to gain 5 litres of whisky (OC of whisky is 10/5 = 2)

Scotland: if it moved 1 unit of labour from whisky to oil it would sacrifice 40 litres of whisky but gain 20 barrels of oil (OC of oil = 40/20 = 2)

Moving 1 unit of labour from oil to whisky production would lead to a sacrifice of 20 barrels of oil to gain 40 litres of whisky (OC of whisky is 20/40 = ½ )

For Scotland the OC of oil is four times higher than that in Russia(2 compared to ½)

15

Comparative Advantage

In Russia, oil can be produced cheaper than in Scotland (Russia only sacrifices 1 litre of whisky to produce 2 extra barrels of oil whereas Scotland would have to sacrifice 2 litres of whisky to produce 1 barrel of oil.

There can be gains from trade if each country specialises in the production of the product in which it has the lower opportunity

cost – Russia should produce oil and Scotland, whisky.

16

Comparative Advantage

Oil (Barrels) Whisky (Litres)

Russia 5 2.5

Scotland 10 20

Total Output= 37.5 15 22.5

Before trade – each country divides its labour between the two products:

After specialisation – each country devotes its resources to that in which it has a comparative advantage.

Oil (Barrels) Whisky (Litres)

Russia 10 0

Scotland 0 40

Total Output=50 10 40

17

Comparative Advantage

Total Output in our example has risen (50 units) and trade can be arranged at a mutually agreed rate that will leave both countries better off than without trade.

In real world there is no central authority deciding which country should produce wine and which should produce oil. Instead international production and trade is determined in the market place where supply and demand rule.

18

Absolute and comparative advantageA numerical exampleProduction possibilities of two cities in the country of USA.

Pairs of Red Socksper Worker per Hour

Pairs of White Socksper Worker per Hour

Boston 3 3

Chicago 2 1

19

per pair of red socks per pair of white socks

Boston60 minutes = 20 minutes3 pairs

60 minutes = 20 minutes3 pairs

Chicago60 minutes = 30 minutes2 pairs

60 minutes = 60 minutes1 pairs

Absolute advantageHow much labor input (in minutes) is needed to produce one pair of socks? We assume that money wages as well as other inputs are the same in both cities. Cost of labour (in minutes)

Boston has an absolute advantage both in producing red socks and white socks because the socks can be produced at a lower cost (20 minutes < 30 minutes and 20 minutes < 60minutes).

Chicago has an absolute disadvantage both in producing red and white socks.

This does not mean that there is no specialization and no trade. To see if specialization and trade are favorable, we have to look at opportunity costs and comparative advantage.

20

Comparative advantage Opportunity costsQuestion: How many pairs of red socks (or white socks) have to be given up to produce a pair of socks of the other colour?

per pair of red socks per pair of white socks

Boston3 = 1 pair of white socks3

3 = 1 pair of red socks3

Chicago1 = 0.5 pair of white socks2

2 = 2 pair of red socks1

Boston has lower opportunity costs in producing white socks (1 < 2) and Chicago has lower opportunity costs in producing red socks (0.5 < 1).Without trade, in Boston the price of 1 pair of red socks would be 1 pair of white socks, whereas in Chicago 1 pair of red socks would be exchanged for 0.5 pair of white socks.

21

Comparative advantage

Boston has a comparative advantage in the production of white socks (lower opportunity costs than Chicago, because 1 < 2), whereas Chicago has a comparative advantage in the production of red socks (because 0.5 < 1).

Thus, Boston should specialize in producing white socks and exporting them to Chicago and Chicago should specialize in producing red socks and exporting them to Boston

22

3.Trade is predicted to benefit a country by making it more efficient when it exports goods which use abundant resources and imports goods which use scarce resources.

4.When countries specialize, they may also be more efficient due to large scale production.

5.Countries may also gain by international immigration and international lending and borrowing. Trade of labor for goods and services and trade of current resources for future resources (lending and borrowing).

6.Imports give citizens of a country access to products and services provided by other nations, which allows for more consumer freedom because people have a wider range of choices. Exports allow companies and citizens to break into other markets to find new

buyers for their products.

GAINS FROM THE TRADE continue:

23

Disadvantages of trade Trade is predicted to benefit countries as a whole in several ways, but trade may harm particular groups within a country

International trade can adversely affect the owners of resources that are used intensively in industries

Trade may have effects on the distribution of income within a country.

24

The Flow of Currencies:

Whisky sold to Italian hotel from UK

€ changed to £

Export earnings for UK(Credit in Balance of Payments)

Map courtesy of http://www.theodora.com

25

The Flow of Currencies:

Oil

Oil from Russia

£ changed into Roubles

Import expenditure for the UK(Debit in balance of payments)

Export earnings for Russia

26

The Balance of Payments A record of all transactions made between one

particular country and all other countries during a specific period of time, usually a year. It compares the difference of the amount of exports and imports of commodities, including all financial exports and imports. A negative balance of payments means that more money is floating out of the country than coming in and vice versa.

A transaction which leads to an inflow of money on behalf of a resident is reported as a credit, and conversely, a transaction which results in an outflow of money towards a non-resident is presented as a debit in the balance of payments.

27

Two main components of Balance of Payments:

• Trade in goods

• Trade in services Current Account=X-M• Income flows (EXPORTS- IMPORTS)

+• Transfer of funds and Capital Account sale of assets and liabilities:

Money used by business to operate and make their products:1 purchases of

Machineries or buildings (Foreign Direct Investment),2 purchase of shares or

bonds,3 loans, deposits or buy and sell of foreign currency by the government.

28

The current account The CA is important in international trade

because it measures the size and the directions of international borrowing and lending.

A) When imports are more than exports ,then a country must finance this account deficit by increasing its net foreign debts.

X<M The world lend us

B) When exports are more than imports, then a country has surplus and finances the current account deficit of its trading partners by lending to them.

X>M The world borrow from us

29

The Balance of Payments

Sources of Funds for a nation, such as exports or the receipts

of loans and investments are recorded as positive or surplus

transactions. Uses of funds ,such as for imports or to invest in

foreign countries are recorded as negative or deficit transactions.

If a country is importing more than it exports trade balance

will be in deficit but this must be balanced in other ways e.g.

funds earned by it’s foreign investments , or by receiving

loans from other countries.

30

Significant issue arise due to trade between countries: currencies and exchange rates

An exchange rate is the price of one money in terms of another Exchange rates measure how much domestic currency can be

exchanged for foreign currency. The issues that governments and business are concerned with

A) How much the imports of goods, expressed

in foreign currencies of foreign markets- countries, cost? B) How much exports of goods expressed in domestic currency cost in foreign markets?

Thus exchange rates play an important role in International Economics because when they are changing this affect trade. Exchange rates are strongly linked with Monetary Policy.

The issues that governments and business are concerned with

31

International Policy Coordination A fundamental problem is how to produce

an acceptable degree of harmony among the international trade and monetary policies of different countries.

But Coordination in International Trade existed since 1947 by the General Agreement on Tariffs and Trade an international treaty and later in 1994 by the World Trade Organisation.

32

GATT:

-is a legal text which specifies rules

-is an organization which facilitated trade negotiations

WTO:

-is an organization which monitor compliance with rules (including GATT)

-resolving trade disputes (disagreements)

-facilitating trade negotiations

33

International Finance is divided into two fields International Trade

& International Finance International trade focuses on transactions of real goods and services across nations.

International finance focuses on financial or monetary transactions across nations. International monetary analysis focuses on the monetary side of the international economy.

Example: purchases of US dollars or financial assets by

Europeans.

Most International Trade involves Monetary Transactions.

34

Models of Economies An open economy is an economy in which international trade takes

place: People and  businesses, can trade in goods and services with other people and businesses in the international community, and also a flow of funds as investment across the border is occurring. Trade can be in the form of managerial exchange, technology transfers, all kinds of goods and services. Most nations around the world have open economies,

As a general rule, open economies are viewed as stronger than closed economies , in which international trade does not occur, and this type of economy tends to be better for companies, investors and individual citizens. For the global economy, however, open economies can become problematic, because when a large trade partner experiences economic difficulties, it can have a ripple effect across the globe, instead of being restricted to that nation alone as it would be in a  closed economies.

35

Cyprus is an Open Economy Cyprus has a market economy dominated by the service sector,

which accounts the four-fifths of GDP. Tourism, financial services, and Real Estate are the most important sectors.

Banking, trade finance, wealth management,foreign exchange trading, fund administration and management and insurance are all fast growing segments of the financial services industry.

The geographical location of Cyprus is like a bridge between East and West and thus it has been transformed into an important trading centre.

A major success story for Cyprus has been the maritime sector. Cyprus is an important ship management centre in the EU and offers a range of business services to the sector. 

36

Cyprus’ trade balance is traditionally in deficit because the island has small domestic market and must import extensively in order to satisfy domestic demand, Imports: fuels and lubricants, machinery, chemicals, vehicles, iron and

steel.

Main import partners: Greece, Israel, the United Kingdom, Germany, Italy

and France.

Exports: manufactured food products, fruit and vegetables(citrus fruit, grapes,

melons, potatoes, vegetables and aromatic herbs), juices, fish, meat products,

wines and also Halloumi cheese <The name «Halloumi» is registered in the

European Union as a «Collective Trade Mark» and on this basis, no other product can

be marketed in the EU under this name> in UK there is a great consumption of

Halloumi cheese.

Main export partners: Greece, the United Kingdom, Germany and

Lebanon.

37

The Current account balance in US dollars in Cyprus was reported at -2.21 billions U.S. dollars in 2009, according to the International Monetary Fund (IMF). In 2015, Cyprus's Current account balance in US dollars is expected to be -3.22 billions U.S. dollars. Current account is all transactions other than those in financial and capital items.

38

Economic Challenges for Cyprus The discovery of natural gas in Cypriot waters

raises the prospect of a transformation of the Cypriot economy. In the short term, the use of gas for electricity production should have a positive impact on electricity prices, while in the longer term, Cyprus can look forward to gas export revenue.

39

UK Open Economy

The UK, a leading trading power and financial center, is the third largest economy in Europe after Germany and France. Agriculture is intensive, highly mechanized, and efficient by European standards, producing about 60% of food needs with less than 2% of the labor force. The UK has large coal, natural gas, and oil resources, but its oil and natural gas reserves are declining and the UK became a net importer of energy in 2005. Services, particularly banking, insurance, and business services, account by far for the largest proportion of GDP.

40

UK Natural resources: Coal, oil, natural gas, tin, limestone, iron ore, salt,

clay, chalk, gypsum, lead, silica. Agriculture Products: cereals, oilseed, potatoes, vegetables, cattle,

sheep, poultry, fish. Services : financial, business, distribution, transport, communication,

hospitality Industry Products: steel,heavy engineering and metal manufacturing, textiles, motor vehicles and aircraft, construction, electronics, chemicals

Major goods exports--manufactured goods, fuels, chemicals, food, beverages, tobacco. Major export markets:U.S., European Union.

Major goods imports--manufactured goods, machinery, fuels, foodstuffs. Major import suppliers:U.S., European Union, and China.

41

42

Appendix GDP doesn’t take into account the depreciation which is

the loss of fixed assets during there use . It is difficult to calculate depreciation thus we use gross.

GDP is the output produced within a country. Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

GNP is the output produced by the citizens of a country who they might live abroad

GNP= GDP + (Income from abroad – Income send to foreign countries)

Net Foreign Factor Income

43

In a closed economy there are neither exports nor imports X=M=0 and Y=GDP=C+I+G

In an open economy Y=GDP=C+I+G +(X-M) GDP = private consumption + gross investment + government

spending + (exports − imports),

PRIVATE AND PUBLIC SAVINGPrivate saving By definition, private savings (S), saving by consumers, is equal to

their disposable income minus their consumption:S = YD – C

Disposable income is the income that remains once consumers have received transfers from the government and paid their taxes. (YD= Y-T)

Therefore, S=Y-T-CPublic saving is equal to taxes minus government spending, T-G If T>G the government runs a budget surplus, so public saving is

positive.If G>T the government runs a budget deficit, so public saving is negative.

Gross private domestic investment includes 3 types of investment: Non residential investment: Expenditures by firms on capital such as tools,

machinery, and factories. Residential Investment: Expenditures on residential structures and

residential equipment that is owned by landlords and rented to tenants. Change in inventories: The change of firm inventories in a given period.

(Inventory: is the goods that are produced by firms but kept to be sold later

Government Spending: Government acquisition of goods and services for

current use to directly satisfy individual or collective needs of the members of

the community.

44

45

Definition of negotiations

To discuss - make a dialogue - with another or others in order to come to terms or reach an agreement: 

E.g. expression: "It is difficult to negotiate where neither will trust"