2nd Reading
b5070
International Economics: Global Markets and Competition (Fifth Edition)
“7x10”
CHAPTER 12
International Money and Finance
Preview
Money supplies across countries affect interest rates and exchange rates that are
tied to international borrowing and lending in financial markets. This chapter
covers topics in international money and finance including:




Loanable funds market and capital account
Exchange rates and international financial markets
The functions and history of money
Money supplies, inflation rates, and exchange rates
INTRODUCTION
Money is the medium of exchange for transactions with cash, bank cards, credit
cards, and checks. The foreign exchange (FX) market involves the exchange of
mediums of exchange.
Lending and borrowing are carried out in money terms with the interest rate
as the cost of borrowing and the return to lending. International finance involves
exchange rates at the times of the loan and repayment.
The consumers, firms, and government of a country can be net lenders or
borrowers in the international credit market. Each country would have its own
loanable funds market but enjoys net benefits through the international market.
International interest rates are the result of lending and borrowing across
countries.
Money as the unit of account for international trade and investment involves
the exchange rate. Money is a store of value for future transactions depending
on its inflation rate. An inflating currency is a poor store of value depreciating
in the FX market.
International financial flows are reported in the capital account of the balance
of payments. Net investment income in the current account is the payment on
international loans. Borrowing countries have capital account surpluses with cash
inflow but current account deficits later. Lending countries have capital account
deficits and net investment income surpluses in the future.
Trade deficits and international borrowing are signals that a country is expected
to grow. Less-develop countries (LDCs) must borrow to acquire capital goods.
The debt is expected to be repaid as output expands.
269
b5070_Ch-12.indd 269
12-Aug-23 6:34:52 AM
2nd Reading
270
b5070
International Economics: Global Markets and Competition (Fifth Edition)
“7x10”
Chapter 12. International Money and Finance
Stocks, bonds, certificates of deposit, futures contracts, options, swaps,
and overnight paper are financial instruments in international finance. Active
international arbitrage occurs among financial intermediaries including banks,
investment houses, and brokers. This international arbitrage involves the FX
market.
The role of government in international financial markets is to manage deficit
spending and control money supply growth. If the money supply grows fast
relative to the rest of the world, the currency depreciates. Government deficit
spending leads to money creation and inflation. Governments balancing their
fiscal budget have low inflation rates and stable exchange rates encouraging
international lending and borrowing.
A. INTERNATIONAL CREDIT MARKETS
This section introduces the international credit market based on borrowing and
lending between countries.
example 12.1
International Financial Markets in the 1890s
International credit became highly developed during the 1890s leading to
economic growth around the world. The two World Wars and the Great
Depression disrupted international financial markets during the first half of the
20th century. International investment relative to world output reached lows
during the 1950s and 1960s but has increased since the late 1970s but still not
reaching the high level of the 1890s.
Two Senses of “Capital”
“Capital” has two meanings in economics. Capital in microeconomics is an input
in production, the machinery and structures combined with labor and natural
resources to produce output. In finance, capital refers to the credit involved with
lending and borrowing. The two meanings are connected. When a firm borrows
from a bank or sells bonds and stocks, it invests in machinery and equipment
to increase future production. Debt and equity purchase new productive capital.
Consumers can expand consumption beyond income by borrowing. Governments
can increase spending beyond tax revenue by selling bonds. If a firm lacks cash
for a worthwhile investment project, it can borrow in the credit market.
A firm deciding whether to invest in a project looks at its rate of return.
Suppose a new machine is expected to create net profit of $40K for one year.
If the machine costs $1 million, its rate of return is 4%.
To determine whether investing in the machine is worthwhile, consider the
opportunity cost of the $1 million. If the interest rate is 3% with no inflation,
the firm with $1 million cash on hand could become a lender and earn $30K.
b5070_Ch-12.indd 270
12-Aug-23 6:34:52 AM
2nd Reading
b5070
International Economics: Global Markets and Competition (Fifth Edition)
A. International Credit Markets
“7x10”
271
The machine offers a higher return. At a market interest rate of 5%, the firm
could earn $50K and should not invest in the machine.
A firm with no cash on hand could borrow to invest in the machine. A net
borrowing cost of $35K would make the borrowing worthwhile. Borrowing cost
of $45K would rule out the borrowing. Higher interest rates increase the cost of
borrowing and discourage investment. Financial capital is turned into productive
capital when firms borrow to invest in new plant and equipment.
Investment spending varies inversely with the interest rate. A higher interest
rate leads to less investment spending.
example 12.2
Emerging Stock Markets
Financial capital is transformed into productive capital when firms sell stocks and
bonds to spend on investment projects. The major international stock markets
are in New York, Tokyo, and London. Stocks are increasingly traded by small
brokers not connected to the major exchanges. There is a high degree of variation
in returns across emerging stock markets. Emerging stock markets have high
average rates of return but also high risk.
Credit Market
An increase in the interest rate lowers the quantity of loans demanded and
increases the quantity of saving. The market for loanable funds (LF) includes
demand and supply for credit in Figure 12.1.
Figure 12.1
The Domestic Credit Market
The demand for loanable funds DLF shows the ranking of investment projects. Supply
SLF comes from households and firms with cash on hand. Competitive market equilibrium
is r  5% with QLF  $10bil  DLF  SLF.
b5070_Ch-12.indd 271
12-Aug-23 6:34:52 AM
2nd Reading
272
b5070
International Economics: Global Markets and Competition (Fifth Edition)
“7x10”
Chapter 12. International Money and Finance
The real interest rate r is the price of borrowing and the return to lending.
The real interest rate is the nominal interest rate minus expected inflation in
the Fisher equation,
ri–π
If r  5%, saving $100 today results in $105 of purchasing power next year.
Borrowing $100 will cost $105 next year. Lending $100 will result in $105
available to spend next year.
At r  4%, the quantity of loans demanded at $12 billion is greater than the
quantity supplied at $8 billion. Financial intermediaries perceive this shortage
and ration by increasing the interest rate. At r  6%, there would be surplus of
$4 billion spurring banks to lower the interest rate. At the market equilibrium
of 5% the quantity of credit supplied equals the quantity demanded.
example 12.3
International Defaults
Bad loans, debt problems, default, and bankruptcy are familiar issues especially
involving loans to governments. Barry Eichengreen (1991) surveys the history
of bad debt. Latin American governments defaulted in the 1820s, followed by
US states during the 1830s and 1840s. Latin American governments defaulted
again in the 1880s along with Egypt, Greece, and Turkey. During the Great
Depression of the 1930s, every debtor country defaulted. Default is a better
option than struggling to pay back bad loans. Lenders tend to make new loans
due to the high potential returns. While bankruptcy laws accommodate default
inside countries, there are no international bankruptcy laws.
The International Credit Market
International financial intermediation occurs as banks try to match borrowers
with lenders in different countries. A small open economy can borrow or lend
at the international interest rate. In Figure 12.1, the small open economy would
borrow $4 billion at the international interest rate of 4%. This inflow would be
a capital account surplus, KA  0. If instead the world interest rate were 6%,
there would be lending with a deficit of $4 billion, KA  0.
The international loanable funds market between two large economies is
pictured in Figure 12.2. As with the excess supply and demand of a product, the
international price is determined between the two countries. The home excess
demand XD is derived from the credit market in Figure 12.1.
The foreign country has its own supply and demand with different lenders
and borrowers. Note that the foreign autarky interest rate r*  3% is less than
the home autarky interest rate r  5%. At r  4% the home excess demand
equals foreign excess supply, XD  XS*. The home country borrows $4 billion
from the foreign country.
b5070_Ch-12.indd 272
12-Aug-23 6:34:52 AM
2nd Reading
b5070
International Economics: Global Markets and Competition (Fifth Edition)
A. International Credit Markets
“7x10”
273
Figure 12.2
The International Credit Market
The home excess demand XD for credit derived from Figure 12.1 has the autarky r 
5%. Excess supply XS* of the foreign country has autarky r*  3%. The international
equilibrium r  4% leads to $4 billion of loans from the foreign to the borrowing home
country.
A small open economy takes the international interest rate. Large economies
lend and borrow at the interest rate clearing the international credit market.
Home borrowers and foreign lenders are better off with international credit in
Figure 12.2 compared to autarky. Home lenders and foreign borrowers would be
better off in autarky. There are total surplus gains—area A for the home country
and B for the foreign country.
The net gain for the home country is the area between XD and the international
interest rate of $20 million. The foreign net gain is the area between foreign XS*
and the international interest rate 4%, area B equal to $20 million. International
gains from the credit market are $40 million.
International Investment Accounting
Financial flows enter the capital account (KA) of the balance of payments (BOP)
as foreign investment. Borrowing countries report positive numbers for KA
surpluses, and lending countries negative numbers for KA deficits.
Net investment income (NII) resulting from KA investments also enters the
BOP. Suppose home investors have a stock of $2,200 billion invested abroad
while foreigners have $1,675 billion invested at home. If the international interest
rate is 4% then 0.04  $2,200 billion  $88 billion is received as investment
b5070_Ch-12.indd 273
12-Aug-23 6:34:52 AM
2nd Reading
274
b5070
International Economics: Global Markets and Competition (Fifth Edition)
“7x10”
Chapter 12. International Money and Finance
income while 0.04  $1675 billion  $67 billion is paid. The NII is then $21
billion. This was the NII surplus reported by the US in 1998.
Estimates of the KA and NII are done by survey. Some years it is not clear
whether the US is a net debtor or creditor due to the statistical discrepancy.
The rapid expansion of international financial activity has made government
surveys less reliable. Multinational firms (MNFs) account for an increasing share
of international financial transactions. Transactions within firms are difficult to
track. International banks have complicated the accounting process.
A typical arrangement would be a branch of a US bank in Mexico buying
$1 million of newly issued stock for an industrial plant in a free trade zone on
the Texas border employing Mexicans who walk daily across a bridge. A bank
in Spain owns 49% of the stock of the Mexican bank. Investors in Texas hold
60% of the deposits in the Mexican bank. Machinery bought for the assembly
line is assembled by a firm based in Michigan that imports components from
Taiwan and employs skilled labor from Panama. Imagine the national income
accounting steps to capture this activity.
International Financial Policy
Governments trying to control or influence international financial flows can place
direct controls on international investment. LDCs and newly industrial countries
(NICs) often forbid the outflow of investment, a policy debated in the developed
countries (DCs). Many governments are reluctant to allow investment inflows
fearing the influence of foreign interests.
One concern is the share of gross domestic product (GDP) that is paid abroad
as interest earnings. Markets naturally determine whether there has been too
much borrowing. A country borrowing only for consumption will lose the ability
to repay the debt. A country borrowing for capital investment will be able to
produce output to repay the debt. Competitive financial markets, not governments
or politicians, should govern financial flows.
Governments often attempt to protect their own financial industries leading
to losses for the country due to the inefficiency. Foreign investment in banking
is not allowed in some countries. While there will always be political pressure
for controls on international investment, competition leads banks to become
more efficient.
example 12.4
Global Financial Instability
International trade and finance slow during a financial crisis. Frederic Mishkin
(1999) notes that lending slows, interest rates rise, and uncertainties increase
during financial crises. Gerard Caprio and Patrick Honohan (1999) find political
interference in bank regulation is apparent in every financial crisis. Jeffrey
Sachs (1995) advocates an international bankruptcy court. Paul Krugman (1998)
b5070_Ch-12.indd 274
12-Aug-23 6:34:52 AM
2nd Reading
b5070
International Economics: Global Markets and Competition (Fifth Edition)
B. Foreign Exchange Rates and International Finance
“7x10”
275
advocates capital outflow controls. Barry Eichengreen (1999) advocates capital
inflow controls. Sebastian Edwards (1999) shows such capital controls are
ineffective. Henry Kaufman (1998) advocates the International Monetary Fund
(IMF) as an international financial regulator. Jeffrey Garten (1998) proposes a
single world currency and a central bank. Kenneth Rogoff (1999) advocates equity
financing. Stanley Fischer (1999) points to the need for transparent international
credit standards. International competition improves the efficiency of banking
systems. Balanced government budgets would diminish instability.
Section A Problems
A1. Draw a foreign credit market that leads to the foreign excess supply in
Figure 12.2.
A2. Find the investment income due on the international loans in Figure 12.2.
Explain which country makes the payment.
A3. Find NII given a 5% interest rate at home and a 6% interest rate abroad with
home-owned investment stock abroad of $1470 billion and foreign-owned stock
at home of $1346 billion. Explain whether there is a surplus or deficit in NII.
A4. Find the KA and NII in Problem A3 if there is a 5% increase in the homeowned stock abroad combined with an increase of 39% in the foreign-owned
capital stock at home.
b5070_Ch-12.indd 275
12-Aug-23 6:34:52 AM