International finance is a discipline in macro-economics which studies the trends in exchange rates, aggregate exports and imports, trade balances, foreign investment and balance of payments, which constitute a global finance system. In particular, international finance studies the inter-relations between these international economic variables and their relationship with domestic aggregate variables.
One of the leading theories in international finance is the Mundell-Fleming model, which was developed in the early 1960s by Nobel Prize economics winner Robert Mundell and British economist J. Marcus Fleming. Their important model integrates international trade and finance into macro-economic theory. This is an extension of the traditional IS-LM model and has been used to demonstrate the effects of monetary and fiscal policies on the exchange rate.
Other significant theories include the Optimum Currency Area (OCA) theory, which campaigns for the merger of currencies, postulating that a common currency in an OCA would maximize economic efficiency. Meanwhile, the Purchasing Power Parity (PPP) theory is a controversial model, which insists that the same goods tend to have the same price on different markets, transaction costs excluded. This theory attempts to quantify the relationship between inflation and exchange rates and states that the change in the purchasing power of a currency will result in a change of its exchange rate.
One of the key monetary systems is the Bretton Woods monetary system, which established rules for international trade and financial relations. Representatives of 44 allied nations agreed on the system during the World War II and the Bretton Woods Agreement was signed in July 1944. In 1971, the United States unilaterally terminated the gold-to-dollar convertibility. This led to the end of the Bretton Woods system.
Most of the international finance institutions were set up in the post-World War II period, under the Bretton Woods system. These include the World Bank, the International Monetary Fund, the International Bank for Reconstruction and Development, and the International Finance Corporation. The choice between fixed and floating exchange rates systems is determined by volatility, risk, inflationary pressure and monetary autonomy. Following the end of the Bretton Woods fixed exchange rate system, many of the developed countries adopted floating rate systems, where the private market determines exchange rates depending on supply and demand.
The foreign exchange market, or the so-called FOREX, is a global decentralized exchange for currencies, which determines the relative value of currencies. The organization of FOREX does not correspond to the traditional idea of a marketplace. This market refers to the operations of leading international banks involved in currency trading. These banking groups are intermediaries in the trade.
Other participants in the foreign exchange market are governments, businesses and individuals. Importers and exporters of goods and services are particularly important participants in FOREX, as they need to exchange currencies for their transactions. International banks, insurers and private equities are also major players in FOREX.
According to Steven Suranovic, author of International Finance Theory and Policy, currency exchange transactions are estimated at more than $1 trillion a day. This compares to the trading volume of USD $70 billion to $100 billion of goods and services. These figures lead economists to the conclusion that the share of investors in FOREX trading is much bigger that the share of importers and exporters.
The exchange rate, also known as the foreign exchange rate, is the rate at which certain currency is exchanged for another. Economic models aim primarily to explain methods of determining exchange rates and the central bank's decisions. Economists have established two main models to determine exchange rates: the interest rate parity model and the purchasing power parity model. While the former studies the actions of international investors and analyzes the link between their decisions and currency supply and demand, the latter examines the impact of importers and exporters of goods and services on FOREX supply and demand. A country can have a fixed or floating exchange rate.
The balance of payments is another key concept in international finance, which defines the international transactions of a country. The country's current account records international transactions for goods and services. The capital account contains its transactions for assets.
International finance theory defines the open economy as one that is involved in international trade. Through international finance analysis, researchers aim to explain the fiscal and monetary decision-making of a government and its effect on aggregate economic variables, including trade balance and exchange rates.