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International Finance
Lecture 1
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Macroeconomics
ECONOMICS
Macroeconomics
Microeconomics
International Finance:
International Trade
Monetary Theories
Exchange Rates
Economic variables: GDP,
Price Level, Interest Rates
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Learning Outcomes
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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.
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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.
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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?
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Validation:
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.
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World Trade in Services
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
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How does trade is being measured?


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.
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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.
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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
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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.
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Comparative Advantage
Russia
Scotland
Oil (Barrels)
Whisky (Litres)
10 or
20 or
5
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.
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Comparative Advantage
Definition: 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)
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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.
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Comparative Advantage
Before trade – each country divides its labour between the two products:
Oil (Barrels)
Whisky (Litres)
Russia
5
2.5
Scotland
10
20
Total Output= 37.5
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22.5
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
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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.
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Absolute and comparative advantage
A numerical example
Production possibilities of two cities in the country of USA.
Pairs of Red Socks
per Worker per Hour
Pairs of White Socks
per Worker per Hour
Boston
3
3
Chicago
2
1
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Absolute advantage
How 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
Chicago
per pair of red socks
per pair of white socks
60 minutes
60 minutes
= 20 minutes
= 20 minutes
3 pairs
3 pairs
60 minutes
60 minutes
= 30 minutes
2 pairs
= 60 minutes
1 pairs
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.
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Comparative advantage
Opportunity costs
Question: How many pairs of red socks (or white socks) have to be given up
to produce a pair of socks of the other colour?
Boston
Chicago
per pair of red socks
per pair of white socks
3
3
= 1 pair of white socks
= 1 pair of red socks
3
3
1
2
= 0.5 pair of white socks
2
= 2 pair of red socks
1
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.
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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
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GAINS FROM THE TRADE continue:
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.
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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.
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The Flow of Currencies:
Whisky sold to Italian hotel from UK
Export earnings for
UK
(Credit in Balance
of Payments)
€ changed to £
Map courtesy of http://www.theodora.com
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The Flow of Currencies:
Oil from Russia
Oil
Export earnings for Russia
£ changed into Roubles
Import expenditure for the UK
(Debit in balance of payments)
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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.
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Two main components of Balance of Payments:
•
•
•
Trade in goods
Trade in services
Income flows
Current Account=X-M
(EXPORTS- IMPORTS)
+
•
Transfer of funds and
sale of assets and liabilities:
Capital Account
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.
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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

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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.
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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
The
issues
that
governments
and
business
are
concerned with

A) How much the imports of goods, expressed
in foreign currencies of foreign marketscountries, 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.
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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.
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 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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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


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 SAVING
Private 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= YT)
Therefore, S=Y-T-C
Public 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.
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
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.
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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"
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