The World of International Finance

The World of International Finance

The federal system of macroeconomics is dependent on many different variables and the government working together as a whole to determine market prices and how the country is fairing economically. This is just the begging as we now look to macroeconomics in a broader sense in international finance. International trade is the backbone of our modern, commercial world, as producers in various nations try to profit from an expanded market, rather than be limited to selling within their own borders. There are many reasons that trade across national borders occurs, including lower production costs in one region versus another, specialized industries, lack or surplus of natural resources and consumer tastes.

To understand international trade we must first look at the exchange rate. Exchange rate is defined as the price at which we can exchange one currency for another is crucial to determine trade. Exchange rate fluctuations have a huge impact on the types of goods countries import or export. In a perfect world all exchange rates would be exact but just like different languages not having exactly straight translations neither do currencies. An example of this is 100 yen increases to 110 yen per dollar. That's why many American's find they can buy more in Japan as well as Japan prices good for less in general. Still the value of a dollar doesn't necessarily stay fixed. A dollar in traded currency can both appreciate and depreciate meaning exchange rate can both fall and rise.

The exchange rate for American currency to foreign currency is determined in the foreign-trade market. The demand and supply curve can further illustrate how the currency translates between foreign countries. As the value of the dollar increases, more dollars will be supplied to the currency market in exchange for euro. Changes in the demand curve represents quantity demanded in dollars in exchange for Euro. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for Euros.

The supply curve for American dollars is the supply of dollars in exchange for example Euros. In this example the curve slopes upward. As the dollar appreciates there will be an increase in the quantity of dollars demanded in exchange for Euros. The factors that lead to increase in demand are interest rates and prices that are on the market. Increases in the US interest rate and decreases in the US prices will increase the demand for dollars, leading to an appreciation of the dollar. Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for Euros, leading to a depreciation of the dollar.

The exchange rate can be quite tricky when dealing with various foreign countries for this we use what is called the real exchange rate, The real exchange rate is defined as the price of US goods and services related to foreign goods and services expressed in as a form of common currency. The exact formula we follow is:

Real exchange rate= (exchange rate x US price index) / foreign price index

Increase in US prices will raise the real exchange rate. Foreign prices and the exchange rate are held at at the same rate for a extended period of time, an increase in US prices will raise the relative price of US goods. An appreciation of the dollars when prices are held constant will increase US goods in comparison to foreign ones. And if foreign prices decline, US goods will become relatively priced higher as well.

Various Economists have found that a country's net exports (exports minus imports) will fall when its real exchange rate increases. Real exchange rates vary over time. Unless they are goods that are easily tradable. Examples of this are gold, silver etc. The tendency for easily tradable goods to sell at the same price is expressed in a common currency is known as the law of one price. Agriculture, metals, commodities, computer chips and other traceable goods follow the law of one price. With the new age of technology internet untraceable goods such as PayPal are another good example of this.

When market exchange rates are determined, they similarly reflect the overall GDP and prices levels between the two countries. According to the theory of purchasing power parity, a unit of any given currency should be able to buy equivalent quantity of goods in all countries. Systematic studies have confirmed that purchasing that purchasing power parity does not give the most accurate predictions for exchange rates. Purchasing power parity is defined as a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. This reasoning is because some services do not leave the country. Such as housing, haircuts, washing services. These services make up about 50% of our market. There is some truth to the purchasing power parity, because exchange rates do reflect differences in the price level between countries.