International Finance

Introduction• It is the branch of economics which deals with the

dynamics of:– International Trade– Exchange rate– Foreign Investment– Global financial system

• It is a branch of International Economics

• It is concerned with understanding all the procedures, techniques & tools related to helping firm in accessing global markets for short/long term funds

• International trade – Applies microeconomic models to

understand the emergence and significance of international trade

• Why? – Theories international trade – Their practical application

• Different types of trade policy – free, restricted, etc.

• How composition of international trade changes due to changes in economic conditions, etc.

• International trade is a cross border trade

• It refers to exchange of capital, goods, services, and across international borders or territories

• Without international trade, nations would be limited to the goods and services produced within their own borders

• Each country has scarce resources / specific skills – better to produce some, rather than all – to optimize the utilization

What is International Trade??

International Trade Theories

Absolute Advantage theory

• Adam Smith – trade b/w two nations is based on absolute advantage

• When one nation is more efficient (has absolute advantage) than another in production of A, but

• Less efficient (has absolute disadvantage) in production of B

• Both nations can gain by each specializing in production of good of its absolute advantage

• Numerical example – next slide

3-1• Assume - Total resources for each X & Y = 200 Mhrs– X requires 10 Mhrs for 1 unit of rice & 20 Mhrs for 1 unit of wheat– Y requires 40 Mhrs for 1 unit of rice & 10 Mhrs for 1 unit of wheat

Country Rice Wheat Before Trade

Absolute Advantage

X – Rice

Y - Wheat

X 10 5

Y 2.5 10

Total 12.5 15

Production with specialization

Consumption after trade of 6 units each

Gain from specialization and trade

Country Rice Wheat Rice Wheat Rice Wheat

X 20 0 14 6 4 1

Y 0 20 6 14 3.5 4

Total 20 20 20 20 7.5 5

Comparative Advantage theory

• Ricardo – even if one nation is less efficient (has absolute disadvantage) in both A & B than other nation

• Still it is beneficial for trade

Example - Comparative Advantage

• Absolute Advantage – X in both products• Comparative Advantage – Y in wheat

Country Rice Wheat

X 10 7.5

Y 2.5 5Total 12.5 12.5

• Total resources for each X & Y = 200 Mhrs• Country X requires10 Mhrs for 1 unit of rice and 13.33 Mhrs

for 1 unit of wheat• Country requires 40 Mhrs for 1 unit of rice and 20 Mhrs for 1

unit of wheat

Example – Gains from trade

Production without specialization

Production with specialization

Consumption after trade of 4 units each

Gain from specialization and trade

Country Rice Wheat Rice Wheat Rice Wheat Rice Wheat

X 10 7.5 15 3.75 11 7.75 1 0.25

Y 2.5 5 0 10 4 6 1.5 1

Total 12.5 12.5 15 13.75 15 13.75 2.5 1.25

Heckscher-ohlin Theory / Factor Endowment Theory - Assumptions:

• 2 countries, 2 goods and 2 Factor of production (FOP) i.e. L, K

• Two factors are available in fixed amounts in each of the two countries; they are fully mobile b/w industries within each country; but immobile b/w countries

• Two countries are alike in every respect except for their endowments of two factors

• For each of the two goods, required technology is available

Heckscher-ohlin Theory / Factor Endowment Theory

• A country is labor-abundant if it has a higher ration of labor to other factors than does the rest of the world

• A product is labor-intensive if labor costs are a greater share of its value than the are of the value of other products.

• A country has comparative advantage in the good that is relatively intensive in the country’s relatively abundant factor

• Export – commodity intensive in its relatively abundant & cheap factor of production (FOP)

• Import – commodity intensive in its relatively scarce & expensive factor of production (FOP)

Empirical Test of H-O Model(Leontief Paradox)

• Wassily W. Leontief made an attempt to test the Heckscher-Ohlin theory empirically.

• In 1954, Leontief found that the U.S. (the most capital-abundant country in the world) exported labor-intensive commodities and

• imported capital-intensive commodities, in contradiction with Heckscher-Ohlin theory ("H-O theory").

• This contradiction is called as Leontief Paradox

• Leontief's paradox undermined the validity of the Heckscher-Ohlin theorem (H-O) theory

Arguments to support HO Model

• Some economists argue that the U.S. has an advantage in highly skilled labor more so than capital.

• This can be seen as viewing "capital" more broadly, to include human capital.

• Using this definition, the exports of the U.S. are very (human) capital-intensive, and not particularly intensive in (unskilled) labor.

Overlapping product Ranges Theory

  • The type, complexity and diversity of product demands of a country increase as country's income increases.

• International trade patterns would follow this principle

• So that countries of similar income per capita levels will trade most intensively having overlapping product demands

• According to Linder - nations with similar demands would develop similar industries.

• These nations would then trade with each other in similar but differentiated goods.

Overlapping product Ranges Theory

• For instance, both the U.S. and Germany are developed countries with a significant demand for cars, so both have large automotive industries (overlapping product demands)

• Rather than one country dominating the industry with a comparative advantage - both countries trade different brands of cars between them.

Product Life Cycle Theory

• The product life-cycle theory looks at the potential export possibilities of a product in five discrete stages in its life-cycle

• Stage 1: Introduction

– A new product is manufactured in the innovating country and sold primarily in that domestic market

– Any overseas sales are generated through exports to other markets

– At this stage the innovating company has little competition in markets abroad.

• Stage 2: Expansion– Sales increase, but so does competition as other firms

enter the arena– At this point, the firm begins some production abroad, to

serve foreign markets and to counter the competition

• Stage 3: Maturity– Exports from the home country decrease, because of

increased production in overseas locations.

– Price has become a critical determinant of competitiveness, so minimising costs becomes an important objective.

– Production may shift to less developed countries to take advantage of lower labour costs

– At this point, domestic production may cease and the product is imported by the home market.

• Stage 4: Sales decline– This occurs because competitors have achieved economies of

scale equal to those of the innovator.

• Stage 5: Demise– The innovator may cease production and leave the declining

market to imitators– Product's popularity has also ceased and consumers seek other

products.

• This theory holds - for products such as consumer durables, synthetic fabrics and electronic equipment;

• Products which have a long time-span from innovation to eventual peak consumer demand.