International Finance

Session 1
Introduction

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Learning Objectives
1.1 Distinguish between international and domestic
finance issues.
1.2 Explain why seven themes recur in international
finance, and discuss their significance.
1.3 Distinguish between the trade and monetary aspects
of international financial economics.

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Preview
• What is international financial economics about?
• International trade topics: Gains from trade, explaining
patterns and volume of trade, effects of government
policies on trade
• International finance topics: Balance of payments,
exchange rate determination, international policy
coordination, capital markets
• International trade versus finance

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What Is International Economics
About? (1 of 3)
• International economics is about how nations interact
through trade of goods and services, flows of money,
and investment.
• International economics is an old subject, but continues
to grow in importance.
• Nations are now more closely linked than ever before.

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What Is International Economics
About? (2 of 3)
• U.S. exports and imports as shares of gross domestic
product have been on an upward trend.
– International trade has roughly tripled in importance
compared to the economy as a whole in the past 50
years.
– Both imports and exports fell substantially in 2009
due to the recession.

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Figure 1.1 Exports and Imports as a
Percentage of U.S. National Income

(Shaded areas indicate U.S. recessions.) Both imports and exports have
risen as a share of the U.S. economy, but imports have risen more.
Source: U.S. Bureau of Economic Analysis
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What Is International Economics
About? (3 of 3)
• Compared to the United States, other countries are
even more tied to international trade.
– Their imports and exports as a share of GDP are
substantially higher.
– The United States, due to its size and diversity of
resources, relies less on international trade than
almost any other country.

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Figure 1.2 Average of Exports and Imports
as Percentages of National Income in 2015

International trade is even more important to most other countries than

it is to the United States.
Source: World Bank
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Gains from Trade (1 of 4)
• That there are gains from trade is probably the most
important insight in international economics.
• Countries selling goods and services to each other
almost always generates mutual benefits.
1. When a buyer and a seller engage in a voluntary
transaction, both can be made better off.
 Norwegian consumers import oranges that they
would have a hard time producing.

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Gains from Trade (2 of 4)
2. How could a country that is the most (least)
efficient producer of everything gain from trade?
 Countries use finite resources to produce what
most productive at (compared to their other
production choices), then trade those products
for what they want to consume.
 Countries can specialize in production, while
consuming many goods and services through
trade.

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Gains from Trade (3 of 4)
3. Trade benefits countries by allowing them to export
goods made with relatively abundant resources and
imports goods made with relatively scarce resources.
4. When countries specialize, they may be more efficient
due to larger-scale production.
5. Countries may also gain by trading current resources
for future resources (international borrowing and
lending) and due to international migration.

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Gains from Trade (4 of 4)
• Trade is predicted to benefit countries as a whole in
several ways, but trade may harm particular groups
within a country.
– International trade can harm the owners of resources
that are used relatively intensively in industries that
compete with imports.
– Trade may therefore affect the distribution of income
within a country.

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Patterns of Trade
• The pattern of trade describes who sells what to whom.
• Differences in climate and resources explain why Brazil
exports coffee and Saudi Arabia exports oil.
• But why does Japan export automobiles, while the U.S.
exports aircraft?
• Why some countries export certain products can stem from
differences in:
– Labor productivity
– Relative supplies of capital, labor and land and their
use in the production of different goods and services

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Effects of Government Policies on
Trade (1 of 2)
• Policy makers affect the amount of trade through
– Tariffs: a tax on imports or exports,
– Quotas: a quantity restriction on imports or exports,
– Export subsidies: a payment to producers that export,
or
– Through other regulations (ex., product specifications)
that exclude foreign products from the market, but still
allow domestic products.
• What are the costs and benefits of these policies?

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Effects of Government Policies on
Trade (2 of 2)
• If a government restricts trade, what are the costs if foreign
governments respond likewise?
• Trade policies are often chosen to cater to special interest
groups, rather than to maximize national welfare.
• Governments tend to adopt tariffs, then negotiate them
down in exchange for reduction in trade barriers of other
countries.

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International Finance Topics
• Exchanging risky assets such as stocks and bonds can
benefit all countries by diversification that reduces the
variability of income – another source of gains from trade.
• Most international trade involves monetary transactions.
• Many monetary events have important consequences for
international trade.

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Balance of Payments
• Governments measure the value of exports and imports,
as well as the value of financial assets that flow into and
out of their countries.
– Trade deficits, where countries import more than they
export in value, may be offset by net inflows of financial
assets.
• The official settlements balance, or the balance of
payments, measures the balance of funds that central
banks use for official international payments.
• All three values are measured in the government’s
national income accounts.

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DOSM
• https://www.dosm.gov.my/v1/index.php?r=column/cthemeByCat&cat=86&bul_id=NU9X
WWtObktzQ1o1clF2cDc1ampGZz09&menu_id=azJjRWpYL0VBYU90TVhpclByWjdMQT
09

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Exchange Rate Determination
• Exchange rates are an important financial issue for
most governments.
• Exchange rates measure how much domestic currency
can be exchanged for foreign currency and thus affect
how much:
– Goods denominated in foreign currency (imports)
cost in the domestic country.
– Goods denominated in domestic currency (exports)
cost in foreign markets.
• Some exchange rates change continually (float) while
others are fixed for periods of time.
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International Policy Coordination
• In an integrated economy, one country’s economic
policies usually affect other countries as well, leading
to the need for some degree of policy coordination.
– Depends on type of exchange rate regime.
• Capital markets, where money is exchanged for
promises to pay in the future, have special concerns
in an international setting:
– Currency fluctuations can alter the value paid.
– Countries, especially developing ones, might
default on debt.

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The International Capital Market
• Capital markets are arrangements by which individuals
and firms exchange money now for promises to pay in
the future.
• International capital markets cope with special
regulations that countries impose on foreign investments.
– Special risks of currency fluctuations and national
default;
– Sometimes offer opportunities to evade regulations
placed on domestic markets.

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World Trade: An Overview
• Largest trading partners of the United States
• Gravity model: Influence of an economy’s size on trade;
Distance, barriers, borders and other trade impediments
• Globalization: then and now
• Changing composition of trade
• Service outsourcing

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Who Trades with Whom?
• More than 30% of world output is sold across national
borders.
– World trade in goods and services exceeded $21
trillion in 2015.
• The 5 largest trading partners with the U.S. in 2015 were
China, Canada, Mexico, Japan, and Germany.
• The largest 15 trading partners with the U.S. accounted
for 75% of the value of U.S. trade in 2015.

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Figure 2.1 Total U.S. Trade with Major
Partners, 2015

U.S. trade—measured as the sum of imports and exports—is mostly

with 15 major partners.
Source: U.S. Department of Commerce.
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Size Matters: The Gravity Model (1 of 3)
• 3 of the top 10 trading partners with the U.S. in 2012
were also the 3 largest European economies: Germany,
the United Kingdom, and France.
• Why does the United States trade more with these
European countries than with others?
– These countries have the largest gross domestic
product (GDP), the value of goods and services
produced in an economy, in Europe.
– Each European country’s share of U.S. trade with
Europe is roughly equal to its share of European GDP.

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Figure 2.2 The Size of European Economies, and
the Value of Their Trade with the United States

Shows the correspondence between the size of different European

economies and those countries’ trade with the United States.
Source: U.S. Department of Commerce, European Commission.
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Size Matters: The Gravity Model (2 of 3)
• The size of an economy is directly related to the volume
of imports and exports.
– Larger economies produce more goods and services,
so they have more to sell in the export market.
– Larger economies generate more income from
the goods and services sold, so they are able to buy
more imports.
• Trade between any two countries is larger, the larger is
either country.

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Size Matters: The Gravity Model (3 of 3)
• The gravity model assumes that size and distance are
important for trade in the following way:
A  Yi  Yj
Tij 
Dij
where A is a constant term
Tij is the value of trade between country i and country j
Yi the GDP of country I, Yj is the GDP of country j
Dij is the distance between country i and country j
A  Yia  Yjb
• Or more generally Tij 
Dijc
where a, b, and c are allowed to differ from 1.
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Using the Gravity Model: Looking for
Anomalies
• A gravity model fits the data on U.S. trade with European
countries well but not perfectly.
• The Netherlands, Belgium and Ireland trade much more
with the United States than predicted by a gravity model.
– Ireland has strong cultural affinity due to common
language and history of migration.
– The Netherlands and Belgium have transport cost
advantages due to their location.

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Impediments to Trade: Distance,
Barriers, and Borders (1 of 4)
Other things besides size matter for trade:
1. Distance between markets influences transportation costs
and therefore the cost of imports and exports.
2. Cultural affinity: close cultural ties, such as a common
language, usually lead to strong economic ties.
3. Geography: ocean harbors and a lack of mountain barriers
make transportation and trade easier.
4. Multinational corporations: corporations spread across
different nations import and export many goods between their
divisions.
5. Borders: crossing borders involves formalities that take time,
often different currencies need to be exchanged, and perhaps
monetary costs like tariffs reduce trade.
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Impediments to Trade: Distance,
Barriers, and Borders (2 of 4)
• Estimates of the effect of distance from the gravity
model predict that a 1% increase in the distance
between countries is associated with a decrease in
the volume of trade of 0.7% to 1%.
• Besides distance, borders increase the cost and time
needed to trade.
• Trade agreements between countries are intended
to reduce the formalities and tariffs needed to cross
borders, and therefore to increase trade.

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Impediments to Trade: Distance,
Barriers, and Borders (3 of 4)
• The U.S. signed a free trade agreement with Mexico
and Canada in 1994, the North American Free Trade
Agreement (NAFTA).
• Because of NAFTA and because Mexico and Canada
are close to the U.S., the amount of trade between the
U.S. and its northern and southern neighbors as a
fraction of GDP is larger than between the U.S. and
European countries.
– Canada’s economy is roughly the same size as
Spain’s (around 10% of EU GDP) but Canada
trades as much with the United States as does all
of Europe.
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Figure 2.3 Economic Size and Trade with
the United States

The United States does markedly more trade with its neighbors than it
does with European economies of the same size.
Source: U.S. Department of Commerce, European Commission.
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Impediments to Trade: Distance,
Barriers, and Borders (4 of 4)
• Yet even with a free trade agreement between the U.S.
and Canada, which use a common language, the border
between these countries still seems to be associated
with a reduction in trade.
• Data shows that there is much more trade between pairs
of Canadian provinces than between Canadian
provinces and U.S. states, even when holding distance
constant.
• Estimates indicate that the U.S.-Canadian border deters
trade as much as if the countries were 1,500-2,500 miles
apart.

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Figure 2.4 Canadian Provinces and U.S.
States that Trade with British Columbia

Source: Statistics Canada, U.S. Department of Commerce.

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Table 2.1 Trade with British Columbia,
as Percent of GDP, 2009
U.S. State at Similar
Canadian Trade as Trade as Distance From British
Province Percent of GDP Percent of GDP Columbia
Alberta 6.9 2.6 Washington
Saskatchewan 2.4 1.0 Montana
Manitoba 2.0 0.3 California
Ontario 1.9 0.2 Ohio
Quebec 1.4 0.1 New York
New Brunswick 2.3 0.2 Maine
Source: Statistics Canada, U.S. Department of Commerce.

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (1 of 3)
• The negative effect of distance on trade according to the
gravity models is significant, but has grown smaller over
time due to modern transportation and communication.
• Technologies that have increased trade:
– Wheels, sails, compasses, railroads, telegraph, steam
power, automobiles, telephones, airplanes, computers,
fax machines, Internet, fiber optics, personal digital
assistants, GPS satellites…

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (2 of 3)
• Political factors, such as wars, can change trade patterns
much more than innovations in transportation and
communication.
• World trade grew rapidly from 1870 to 1913.
– Then it suffered a sharp decline due to the two world
wars and the Great Depression.
– It started to recover around 1945 but did not recover
fully until around 1970.

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (3 of 3)
• Since 1970, world trade as a fraction of world GDP has
achieved unprecedented heights.
• Vertical disintegration of production has contributed to the
rise in the value of world trade through extensive cross-
shipping of components.
– A $100 product can give rise to $200 or $300 worth of
international trade flows.

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Figure 2.5 The Fall and Rise of World
Trade

The ratio of world exports of manufactured goods to world industrial production

rose in the decades before World War I but fell sharply in the face of wars and
protectionism. It didn’t return to 1913 levels until the 1970s but has since reached
new heights.
Source: UN Monthly Bulletin of Statistics, World Trade Organization.
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What Do We Trade? (1 of 3)
• What kinds of products do nations trade now, and how
does this composition compare to the past?
• Most (about 57%) of the volume of trade today is in
manufactured products such as automobiles, computers,
and clothing.
– Services such as shipping, insurance, legal fees, and
spending by tourists account for about 24% of the
volume of trade.
– Mineral products (ex., petroleum, coal, copper)
remain an important part of world trade at 12%
– Agricultural products are a relatively small part of
trade at 8%.
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Figure 2.6 The Composition of World
Trade, 2015

Most world trade is in manufactured goods, but minerals—mainly oil—

remain important.
Source: World Trade Organization.
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What Do We Trade? (2 of 3)
• In the past, a large fraction of the volume of trade came
from agricultural and mineral products.
– In 1910, Britain mainly imported agricultural and
mineral products, although manufactured products still
represented most of the volume of exports.
– In 1910, the U.S. mainly imported and exported
agricultural products and mineral products.
– In 2002, manufactured products made up most of the
volume of imports and exports for both countries.

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Table 2.2 Manufactured Goods as a
Percent of Merchandise Trade
blan Exports of Imports of United Exports of Imports of
k United Kingdom Kingdom United States United States
1910 75.4 24.5 47.5 60.7

2015 72.3 73.6 74.8 78.4

Source: 1910 data from Simon Kuznets, Modern Economic Growth: Rate,
Structure and Speed. New Haven: Yale Univ. Press, 1966. 2015 data from
World Trade Organization.

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What Do We Trade? (3 of 3)
• Low- and middle-income countries have also changed
the composition of their trade.
– In 2001, about 65% of exports from low- and middle-
income countries were manufactured products, and
only 10% of exports were agricultural products.
– In 1960, about 58% of exports from low- and middle-
income countries were agricultural products and only
12% of exports were manufactured products.
• More than 90 percent of the exports of China, the largest
developing country and a rapidly growing force in world
trade, consist of manufactured goods.

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Figure 2.7 The Changing Composition of
Developing-Country Exports

Over the past 50 years, the exports of developing countries have shifted
toward manufactures.
Source: United Nations Council on Trade and Development.
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Service Outsourcing (1 of 2)
• Service outsourcing (or offshoring) occurs when a firm
that provides services moves its operations to a foreign
location.
– Service outsourcing can occur for services that can be
transmitted electronically.
 A firm may move its customer service centers
whose telephone calls can be transmitted
electronically to a foreign location.
• Other services may not lend themselves to being
performed remotely.

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Service Outsourcing (2 of 2)
• Service outsourcing is currently not a significant part of
trade.
– Some jobs are “tradable” and thus have the potential
to be outsourced.
– Most jobs (about 60%) need to be done close to the
customer, making them nontradable.

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Figure 2.8 Tradable Industries’ Share
of Employment

Estimates based on trade within the United States suggest that trade in services may
eventually become bigger than trade in manufactures.

Source: J. Bradford Jensen and Lori. G. Kletzer, “Tradable Services: Understanding the
Scope and Impact of Services Outsourcing,” Peterson Institute of Economics Working
Paper 5–09, May 2005.
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Malaysian Trade
• 2020

• https://www.matrade.gov.my/en/malaysian-exporters/services-for-exporters/trade-
market-information/trade-statistics/28-malaysian-exporters/trade-statistics/5084-
summary-of-malaysias-monthly-trade-2020

• 2019

• https://www.matrade.gov.my/en/malaysian-exporters/services-for-exporters/trade-
market-information/trade-statistics/28-malaysian-exporters/trade-statistics/4542-
summary-of-malaysias-monthly-trade-2019

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Summary (1 of 2)
1. The 5 largest trading partners with the U.S. are China,
Canada, Mexico, Japan, and Germany.
2. The largest economies in the EU undertake the largest
fraction of the total trade between the EU and the U.S.
3. The gravity model predicts that the volume of trade is
directly related to the GDP of each trading partner and is
inversely related to the distance between them.

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Summary (2 of 2)
4. Besides size and distance, culture, geography,
multinational corporations, and the existence of borders
influence trade.
5. Modern transportation and communication have
increased trade, but political factors have influenced trade
more in history.
6. Today, most trade is in manufactured goods, while
historically agricultural and mineral products made up
most of trade.

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