INTERNATIONAL FINANCE

International Finance



International Finance

Introduction

International finance is the branch of international economics that deals with a variety of issues that are related to macroeconomic behavior, such as the determination of real income and the allocation of consumption over time, in a country that engages in international trade. As such, this field of study is also often referred to as international macroeconomics. Specific topics included in international finance include the balance of payments, exchange rate determination, and macroeconomic policy in an open economy. At the heart of this field is the fact that international economic activity between and among nations seldom, if ever, is perfectly balanced. Therefore, financial resources will tend to flow across borders. The core of international finance is the study of these flows, the markets where this activity takes place, the impacts these flows have on economic behavior, and the interaction between these flows and economic policy.

Balance of Payments and Models of Current Account Behavior

The balance of payments registers the international financial position of a country, using a double-entry bookkeeping approach to tabulate the market value of the transactions in goods, services, and financial assets between the country's residents and the residents of the rest of the world. Like gross domestic product (GDP), the balance of payments encompasses transactions in goods and services produced during the year, but, unlike the GDP, the balance also encompasses transactions in assets. In addition to categorizing international transactions as debits or credits, the balance of payments separates private transactions in goods and services into the current account and transactions in assets into the capital account. Official government transactions, undertaken to affect the exchange rate, are typically separated from private transactions in balance of payments accounting (Engel & West, 2005).

The pattern of entries in the table follows the convention that appears in most official publications. Debit entries in the table are denoted with minus signs; credit entries are unsigned. International trade in goods and services appears at the top of the table. Income inpayments (outpayments) represent earnings paid to domestic (foreign) factors of production (wages, profits, rents, interest) by foreign (domestic) firms. Net transfers represent net flows of gifts, charity, foreign aid, and other one-way payments. In this example, outflows exceeded inflows, and hence the entry carries a negative sign.

Capital flows denote net changes in financial holdings of that type of asset (or liability) over the year valued at market prices at the time the transaction occurred. Long-term flows refer to purchases or sales of assets whose remaining time to maturity exceeds one year. Examples of inflows include purchases of domestic firms by foreign firms, foreign purchases of domestically issued equity, and long-term loans from foreigners to domestic residents. Examples of outflows include domestic purchases of foreign firms or foreign equity as well as long-term loans made to foreigners. Other capital flows include short-term loans such as trade credit as well as international changes in holdings of bank deposits. If foreign money comes into the country in these forms, then those amounts would be ...