International Finance: Exchange Rates, Trade Balances and International Financial Markets

The world of international finance is constantly evolving. Factors such as digital technologies, sustainability, shifting demographics and geopolitics are shaping the future of finance and affecting economies worldwide.¹ To understand these changes, you first have to understand how international financial systems work and why they matter.

This post will explore the history, function and challenges of international finance.

The terms ‘international finance’ and ‘international macroeconomics’ refer to cooperative financial interactions between two or more countries.² As a field of study, international finance looks into the processes that drive the global economy. These processes affect the lives of individuals all over the world.

International financial cooperation as we know it today first emerged after the Second World War, with the creation of the Bretton Woods System.³ This new international monetary system was devised in Bretton Woods, New Hampshire, in July 1944, by delegates from forty-four nations. It sought to create stable economic growth worldwide. Although the Bretton Woods System dissolved in the early 1970s, it launched the institutions that still shape global markets today, such as the International Monetary Fund (IMF), the World Bank and the World Trade Organization (WTO).⁴

These organizations facilitate international transactions and set standards among governments and commercial banks. Fluctuations in exchange rates and other volatile factors, however, still drive disparities in global economies despite institutional oversight.

A key factor in international finance is the concept of the currency exchange rate. Exchange rates, or the cost of one currency unit compared to the cost of another, fluctuate based on a number of factors, including interest rates, inflation and political stability within a country. Exchange rates can involve a domestic currency and a foreign currency (say, the U.S. Dollar and the Euro) or two foreign currencies (the Euro and the Japanese Yen, for instance).

Some currencies have a fixed currency exchange rate, meaning the rate is pegged to a more stable or influential currency. Floating currencies, such as the U.S. Dollar, rise and fall with market changes.⁵ There are advantages and disadvantages to each type. Developing economies, for instance, typically choose a fixed, or pegged, exchange rate regimen to establish stable growth. Neither system is perfect, and part of a thorough financial education is understanding the impact and function of each type.

Trade balances are the difference between the values of a country’s imports and exports. When a country imports more goods and services than it exports, it has an account deficit or trade deficit.⁶

Trade deficits are not necessarily indicative of a distressed economy, but they can have consequences for the global market. International financial organizations strive to address deficits and surpluses with fiscal policies, incentives and currency devaluation.

International financial markets facilitate cross-border exchanges and investments. These exchanges are made by governments and private actors, such as corporations. Currencies, bonds, equities and commodities are all traded in international markets, driving economic growth and diversifying investment portfolios for individuals and organizations.

It’s impossible to discuss international markets without acknowledging the role of emerging economies. As historically poor nations take a more active role on the global stage, they bring about new investment opportunities and drive economic growth across sectors.⁷

Foreign direct investment (FDI) is a type of cross-border investment in which an investor in one economy takes a long-term stake in a company or enterprise in another.⁸ Ideally, these investments benefit both the host and home economies, bringing a profit to the investor and supporting growth in the host country. However, they can also lead to capital flight, or the mass export of money earned in a country.⁹

FDI is just one example of international capital flow in the global economy. As globalization and the emergence of developing economies drive more capital flow, international organizations are under increasing pressure to minimize risks such as capital flight and volatility.

The role of international financial institutions such as the IMF is to stabilize the global economy, facilitate overseas exchanges and encourage healthy economic growth. This is done through cooperation and the formation of bilateral or multilateral agreements.

The World Bank, for example, provides funding for new projects in developing economies.¹⁰ Regional institutions such as the European Union provide a platform for regional economic integration. While international financial institutions are necessary for a thriving global economy, they are, as is any international institution, flawed. It’s crucial to understand the goals, benefits and drawbacks of these organizations in order to work toward future improvements.

Despite international efforts to stabilize the global economy, currency crises have occurred throughout modern history. A notable example is the Asian economic crisis of 1997, in which fast growth and large trade deficits led to the rapid devaluation of Southeast Asian currencies.¹¹

Currency crises can be caused by a number of factors. Political instability, debt and failed investments all play a role. It’s the job of government leaders and international organizations to learn from past crises and mitigate future instability with adaptive policies.

International finance is in a state of flux. Advancing digital technologies such as blockchain, cryptocurrencies and digital transfer methods are reshaping the way currencies flow between nations. In addition, the ongoing climate crisis presents a pressing need for nations to invest in clean energy and decrease their investments in fossil fuels.

These challenges will shape the future of international finance. A smooth transition to green investments and digital currencies requires extensive international cooperation and delicate changes to monetary policy. Students who begin their journey into the world of international finance today will help shape these changes, acting on behalf of companies, investors and government organizations.

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