Lecture 1
November 15, 2022 9:03 AM
Title: International finance: refresher and introduction
• This course is based on some analytical tools that allow us to dissect the international
financial system. Tools:
WR the 3 analytical • Balance sheets to measure stocks
tools used in the ○ Changes in balance sheets to measure flows
course? WD each
study? • Balance of Payments (BoP) to measure international payment flows
• System of national accounts to measure national macroeconomic flows
WI the use of the
financial system? • The financial system connects surplus and deficit units, nationally and internationally
• This is done by using money
○ Money is changes in balance sheets managed by financial institutions
○ Apart from currencies there are instruments that are not used for
settlement but are part of the hierarchy (i.e.: bonds, derivatives, etc.)
• Balance sheets help you to distinguish buying/selling from investment, and to keep
track of assets and liabilities.
• Financial interactions are interactions between balance sheets
WR the national
accounts (NA)? Key points national financial systems:
• National accounts: system that organizes the national flows (C, I, G, NX)
WI the BoP?
• The BoP is an accounting system to monitor international flows (KA, CA)
WR the 3 key
questions for
national financial • National financial systems are characterized by the answers to three questions:
systems? 1. Who has the power to issue the country’s money?
○ Historically, it is the gov't who has the power to issue it. The gov't licensed
it exclusively to banks (money creation monopoly)
▪ Control by the gov't leads to accruing 'seigniorage': the power to
issue money = free purchasing power.
2. How will the amount of money increase?
○ Lending by banks.
▪ Lending is money creation.
▪ Payment is money transfer.
3. How to balance the demands of money issuers and takers of money?
○ Through double-entry bookkeeping and the legal system around it
(accountants, auditors, reporting standards, valuation rules, bankruptcy
procedures)
WD Mehrling's
hierarchy stress?
Key points the natural hierarchy of money:
• Mehrling's 'hierarchy of money' model connects two opposing theories (scarcity and
elasticity of money). His theory talks about ´how money relate to other financial assets
and liabilities´.
•
Is the moneyness of
an asset fixed? W
determines it?
WI the relation
between money and • Moneyness of an asset is not fixed (and nor is its 'creditness')
credit? ○ It is determined by its ability to be used as means of settlements
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, ○ It is determined by its ability to be used as means of settlements
WR the dynamics of he • What is money on one level is credit on the next.
system? ○ Lower 'monies' are settled in higher money, but not vice versa
• The money system is hierarchical (not by law, but inherently)
○ The dynamics of the system are the flattening and steepening of the
WR the 2 broad ways hierarchy.
in which the state
can influence the
money supply in the • Government and money:
hands of the private • The gov't has 2 broad ways in which it can change the amount of money (i.e.:
sector? purchasing power, facilitating economic activity) in the hands of the private
sector (i.e.: firms and households)
○ Fiscal policy: raise taxes and spend
▪ The balance of spending and taxing is the net amount of money
injected/drained by the government (i.e.: econ. growth or
contraction)
○ Monetary policy (not done by gov't but by CB): set interest rates, regulate
bank credit.
▪ This influences how much money commercial banks inject in the
WI trade openness?
economy (i.e.: econ. growth)
Key points of the international monetary system
WI KA openness? • Trade openness (open current accounts, CA): allowing imports and exports (and their
payments)
HR int'l transactions • Capital account (KA) openness: allowing non-trade related int'l payments (e.g.:
different from lending, borrowing, investing)
national? (2 things)
• International transactions are different (from national) in that they change int'l
reserves and domestic money supply
•
WR the 4 big issues
in global finance
(and the int'l
monetary system)?
• There are 4 big issues in global finance (and int'l monetary system):
1. What will be the 'money of the world'?
○ In what currency will transaction 3 (in the figure above) take place? What
currency is used to keep int'l reserves?
○ The 'money of the world' is the denomination of reserves.
2. Will exchange rates (XR) be fixed or floating?
○ What is the convertibility between assets/liabilities denominated in
different currencies? What is the rate at which the assets of transaction 2
translate into liabilities of transaction 4?
○ Its XR determines how much local currency (LC) you get for USD ($)
3. Will non-trade capital flows be allowed?
○ Will the CB allow capital to flow in/out? Will transactions 2 and 3 take
place?
○ Free K flows help pay for CA deficits, but also build up income account
revenues/costs
4. What to do with imbalances?
○ What will be the consequence of the int'l exchange of financial
assets/liabilities (perhaps caused by the exchange of goods/services)?
○ (Im)balances may undermine/support continued int'l trade and
investment… or cause a crisis.
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, investment… or cause a crisis.
▪ National monetary sovereignty: Gov'ts must balance flexible XRs,
interest rate setting and K flows (e.g.: Eurozone)
Key points of the Balance of Payments (BoP)
• The BoP is an international balance sheet (accounting system)
WI the BoP? • It summarizes the balance sheets of firms, households, gov'ts, banks, and central
banks.
• Main components:
WR the main ○ Current Account (CA): income account + trade account
components of the ▪ What have I EARNED from trade, work, lending, or investing?
BoP?
▪ What have I PAYED FOR trade, work, lending, or investing?
*WD the CA ▪ The difference between these 2 is the CA balance!
illustrate? ○ Capital Account (KA):
*WD the KA ▪ If CA deficit (=KA surplus): How have I attracted the money to pay
illustrate? for the current account balance?
▪ If CA surplus (=KA deficit): How have I invested that money (CA
balance)?
HD the CA relate to • Current Account deficit ≡ Capital Account surplus
the KA?
○ Imports > exports means that excess financial means have been found to
pay for them
WD a CA surplus mean ▪ A country's financial claims on the ROW (its assets) have decreased,
for the KA?
or the ROW's claims on the country (its liabilities) increased.
○ A KA surplus is a financial inflow (NET!), which is used to finance a CA
deficit (a financial outflow).
HD the KA change when
there are investments ▪ NET because gross K inflows can also be invested in financial
in financial markets markets (instead of to pay for imports). If all K inflows are used this
only? way, the KA surplus does not change (NET K flows are zero).
Is forex part of the ○ In the BoP logic, foreign exchange is NOT part of the economy
economy in the BoP • The economy has domestic money, not foreign money. So any
logic? foreign money received in the CA (a forex inflow, with '+' sign) is by
definition invested in some foreign-money denominated asset,
which is registered in the KA (a forex outflow, with '-' sign).
○ Check table 15.2 in Cypher & Dietz
• Bottom line about BoP: for a net exporter, CA shows sources of int'l money, KA shows
uses of int'l money.
•
• Important considerations:
HD all dollars end up
as official reserves? • Dollars end up as official CB reserves even if paid to private parties
Draw BS of agents ○ That's why trade and K are important to gov't int'l financial policy: it
(firms, banks, CBs) determines how much USD they have to do those policies
in 2 countries …
▪ Link to Angrick and the constraint of developing countries to have a
CA surplus or net K inflows via private investments
• Foreign money does not actually flow into the country
D foreign money ○ Theoretically: USD 'flow' in from foreign investors and 'flow' out to US T-
actually flow into bill sellers (in the process, domestic money supply increases)
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, actually flow into bill sellers (in the process, domestic money supply increases)
the country? ○ In practice: USD never leave the US (money is #s in computers)
▪ Foreign money is useless in the domestic economy, which uses
domestic currency.
▪ USD that 'flowed out' of the US are simply kept in US bank accounts
owned by non-US parties.
• Gov't FX reserves are foreign financial assets (they are not a stash of cash in the
country)
○ Foreign investment is an exchange of private domestic assets (e.g.: equity)
for official foreign assets (e.g.: T-bills)
• Openness adds 2 policy tasks for the government:
WR the 2 tasks that • Exchange rate policy
openness add to the
gov't? ○ The exchange rate (XR) is determined by supply and demand of local
currency (LC) relative to USD (LC/$ exchange rate)
▪ Supply and demand are determined BOTH by trade and capital flows
HR XR determined?
(forget about (more by K flows)
Mehrling for now…) □ A lower LC/$ XR: imports are cheaper, which is bad for the
exports sector
WR the possible XR ○ Possible XR regimes:
regimes? ▪ Floating XR: do nothing. The market will determine the XR.
▪ Fixed XR: intervene.
□ To increase LC/$ rate: offer $ for LC (if you have them!)
□ To decrease LC/$ rate: offer LC for $ (you will always be able
to make more LC)
Key points of sectoral balances and the fundamental identity
• The national accounts and GDP
WR the 3 • GDP is the sum of:
interpretations of a. The market value of all final goods and services produced (production
GDP? perspective)
b. Primary incomes in the economy (income perspective)
c. The expenditures on the final uses of goods and services (expenditure
perspective)
▪ Under this approach we can disaggregate GDP( ) into several
components: household consumption ( ), firm investment ( ),
government expenditure minus taxation ( ), and expenditures
on imports ( ):
□
WD GDP measure?
(WD it not measure?) □ GDP measures economic activity within a country, so it does
not measure some things (i.e.: when import increases; when
housing booms where households borrow more, get more
indebted and see price of houses rise)
GDP measures production and income, not wealth:
◊ Wealth is measured by the volume and prices of
assets, but GDP measures income and not assets.
House prices and household borrowing are
wealth and debt (negative wealth), not
production and income. Thus, when assets
are traded this is not measured by GDP.
• The ' fundamental identity': a sectoral balances equation
• Builds on the expenditures approach to GDP
• In an open economy, the world has 3 sectors:
○ 1. Domestic private sector. Made of:
WR the 3 sectors in ▪ Domestic households
an economy? ▪ Domestic businesses
○ 2. Government sector
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