The Role of International Finance in the Global Economy

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Table of Contents

Introduction
The Global Economy
Exchange Rates
Cross-border financial flows
Conclusion
Works Cited

Introduction

Ever since explorers discovered that the world was round and that there is a route that allows for the circumnavigation of the globe, international trade and international finance became an important part of the history of mankind. But since the Middle Ages, modes of transportation and communication evolved to such a degree that it is now easy not only to travel around the world but to move goods, information, people, and money so much quickly from point A to point B. As a result a new global economy was created wherein there is a constant exchange of goods and services from one country to the next. By simply focusing on two major components of international finance – exchange rates and cross-border financial flows – one can have a basic idea as to how international finance is affecting the global economy.

The Global Economy

Beginning in the 20^th century and intensifying in the 21^st century the whole planet is moving towards globalization. This simply means that nations are now interdependent on each other and that there can be no single nation that can even pretend to be an island – isolated and self-sufficient. U.S. companies are building factories in China while emerging markets in Asia are very much dependent on foreign investments. It is also common knowledge that multinational companies are more than willing to tap different suppliers all over the world rather than to depend on one partner to supply their needs. It is much cheaper and much more efficient to breakdown a project into smaller pieces and subcontract it to various companies able to focus on one aspect of the job rather than to give the bulk of the project to one group.

The link between international finance and the global economy can be studied independent of other factors. But in order to have an accurate description of how international finance affects the global economy it is imperative to at least have an overview of a related concept – globalization. This term is not new, it has been around since the 1990s and according to one economist, globalization is the “…declining significance of national borders brought about by increasing trade, the spread of information technology, cross-border financial flows and cultural transfers” (Terril, par. 4). While the impact of information technology is very much evident the effect of increasing trade and cross-border financial flows are the main reason why a global economy is possible and it is the international finance that is the lifeblood of global commerce.

Exchange Rates

The role of international finance in the global economy can be understood more clearly when applied towards the analysis of exchange rates and cross-border financial flows. Focusing first on exchange rates it is commonly understood as the price of one country’s currency expressed in another country’s currency (Heakal, par. 2). In order to simplify this process the price of currencies are expressed in terms of U.S. dollars while the dollar on the other hand is compared to the Japanese yen or the euro. For instance, in the beginning of 2009, 1 Japanese yen is equal to 0.0107339 USD. And one US dollar on the other hand is equivalent to 0.735491 Euro. This simply means that for a Japanese citizen a US dollar is more valuable than Japanese yen. But for an American the US dollar is of lesser value compared to the Euro.

With regards to exchange rates there are two types – fixed and floating. In recent times the floating exchange rate is preferred by most economies as it has proven to be more efficient in determining the long term value of a currency as well as in creating equilibrium in international market (Heakal, par. 16). In a floating exchange rate the price of the currency is determined by supply and demand.

Supply and demand is in turn determined by the other components of international finance such as international trade, foreign investments, remittances etc. If the demand for a currency is low then its value will decrease. If the value of the currency will decrease then it has a limited purchasing capability making it very expensive to purchase imported goods. This is a good thing if imported goods are considered a luxury and therefore will encourage citizens to purchase the local alternative, thus stimulating economic growth in the local economy. But if imported goods are crucial to the economy such as machineries used for agriculture then the nation will suffer.

If the said country needs to import foodstuff from abroad then there is a risk that its citizens will go hungry for they could no longer afford to purchase what was once considered as affordable. But if the demand for the same currency is high then the value also goes up. Yet this has both positive and negative effects. If a currency appreciates then its purchasing power also increases, meaning it can import more goods from abroad. On the other hand if the currency appreciates it can also mean that the products produced by that country becomes more expensive and therefore less attractive for buyers from other nations.

One of the best ways to illustrate how exchange rates influence the global economy is to find out how the Japanese yen, the U.S. dollar and Mexican pesos are traded and used in the global economy. The best way to start is to apply knowledge gained from the discussion of exchange rates and use it in a simplified model. For instance if a Japanese national would like to buy a pair of Nike sneakers he or she will have to first determine the price. If the asking price is US$ 100 then the buyer will have to first acquire 9, 290 Japanese yen in order to purchase the said US-made sneakers.

This is a double-edged sword for the United States. The high value of the dollar as compared to the yen will allow Americans to import more from the Japanese economy because of its significant purchasing power over the Japanese yen. But on the other hand the Japanese would find it expensive to purchase the aforementioned Nike sneakers and they can decide to purchase a local alternative. Thus, the manufacturers of Nike shoes will experience a loss of profit due to the steep price of the commodity which is linked to the exchange rate. It does not matter if the price of Nike sneakers remained constant for a decade, the sudden devaluation of the Japanese yen can make it impossible for the Japanese people to buy American-made shoes and thus create a problem for the Nike brand.

The Japanese are known to be very competitive and instead of simply rejecting the expensive American-made rubber shoes they can decide to create a new industry similar to what they had created with the auto industry. Several decades ago the Japanese decided to go against the US auto industry and after a few decades of intense marketing Japanese car models such as Honda and Mitsubishi is so common that it is hard to believe that there was a time when Japanese automakers had a hard time convincing Americans to buy their products. Japanese businessmen can decide to create an alternative or they can decide to look for other suppliers that can meet their demand for rubber shoes.

In another example a Mexican citizen will have to have 13 Mexican pesos to purchase a single U.S. dollar. Again, the US currency is much superior in this exchange rate which will greatly affect the way these two countries will trade goods and services. For instance if a Mexican-made sandals sells for 100 Mexican pesos an American buyer will only have to shell out a mere 7 USD in order to purchase the said item. If the average American can earn more than 7 dollars per hour of work then that Mexican-made footwear is very cheap. Assuming that the said sandals are of high quality then many Americans will consider buying Mexican-made sandals.

Again there are good and bad implications for both nations. For Mexican manufacturers, a sudden increase in the demand of Mexican-made products will cause the market to overheat meaning the increase in demand will increase the price of raw commodities. This can also mean that Mexican citizens can find themselves in a situation where they could no longer afford their own locally made goods. After some time the 100 peso sandals can become 200 pesos if the demand continues to rise. The American buyers may react negatively to the two-fold increase in price and may be forced to find an alternative source for the sandals. Their search may lead them to other suppliers. So if China for example is able to supply the same product at a much lower price where instead of paying for US$20 per pair Americans will only have to spend US$5 dollars, American buyers will be more than willing to import the said product if it makes sense to buy from another supplier.

Cross-border financial flows

Aside from the payments made on goods and services there are two major reasons why funds move in and out from one country to the next. The first one is called foreign investment and the other one is called remittances. One major aspect of international finance is foreign investment and aside from international trade there is no other factor that influences the global economy than the inflow of money coming from foreign investors. Using the simplified model mentioned above the US shoe manufacturers such as the Nike can create strategies that will lessen the negative effect of an appreciating US currency versus the Japanese yen or the Mexican pesos.

Nike can use the strong US currency to its advantage by creating factories in places like China or Malaysia. The high value of the US dollar will allow Nike to purchase land and raw materials at a much cheaper rate. It can easily build more factories in these regions as compared to building the same number of factories in the US mainland. Since the value of the dollar is high compared to the Chinese or Malaysian currencies then it also mean that labor is cheap. Thus, if everything is cheap then they can create a much cheaper pair of Nike sneakers. This in turn will create more profit for the company and more importantly encourage more buyers.

All of these are made possible by foreign investments. Money coming in from other countries can easily stimulate the local as well as the global economy. A new Nike facility means more opportunities for the local business sector. There will be an increase in the demand for skilled workers as well as various professionals – engineers to develop and maintain the factory as well as managers that will help in sustaining the daily operation of the said factory. Overall there is a positive economic impact in the area where the factory is situated.

Aside from foreign investments there is another way by which money can move from country A to country B. This is none other than remittances. In the preceding discussion buyers and sellers reacted to the changes in the price of the commodities as dictated by the exchange rate. But the discussion was limited to whether a buyer will continue to purchase from the same supplier, find an alternative source or use foreign investments as a tool to stay competitive. But another effect of differing exchange rates is not only limited to the movement of goods but also the movement of human capital.

If the US currency and the euro will continue to appreciate then these regions will continue to attract foreign workers. Earning dollars and euros will allow these foreign workers the same purchasing power enjoyed by the residents of these highly industrialized countries. But instead of spending all their hard earned money in the US mainland or in Europe these foreign workers will send a sizable portion of their income to their places of origin. According to one report, “Over the past few years, remittances have become a major phenomenon in international finance … the practice of migrants in developed countries sending funds home to family members still residing in developing nations has been occurring for many decades, the magnitude of remittance has skyrocketed” (Carrasco & Ro, par. 1). In other words there is a significant amount of monies flowing out of the US economy and into Latin America and Asia.

These funds send by “remitters” will no doubt stimulate the local economy and in turn will affect the global economy. For those who are in poorer countries, remittances will allow them to have more spending power. If in the past they could not afford to purchase imported goods then this time around they can develop a taste for luxurious items. This will create a demand for US or European made products that will impact the global economy. But there is also a negative effect when it comes to the inflow of monies sent by foreign workers. This can result in a strengthening of the local currency making their exported products more expensive and therefore less desirable for foreign buyers.

Conclusion

International finance plays a major role in the global economy. Since international finance is a very broad topic the discussion was limited to the analysis of exchange rates and cross-border financial flows. But even in limiting the discussion to these two it was clear that exchange rates and the flow of money from one country to the next is enough to affect the global economy. The exchange rate alone is a major factor that can change the economic policies of a certain country and influence how companies and business leaders react to changing trends due to the appreciation and devaluation of a particular currency.

It is impossible to track down the chain reaction of events created by the appreciation or devaluation of the Japanese yen for instance. Thus, a simplified model based on real-life situations was used to provide an overview of the impact of international finance to the global economy. With regards to the exchange rates a sudden change in the value of a currency can create a bonanza for those who participated in international trade. In some cases it can be a cause for concern. It is a complicated situation which is exacerbated by globalization – the interconnectedness and interdependence of nations irregardless of politics and ideologies.

Foreign investments and remittances on the other hand can also impact the global economy by creating more jobs, creating more opportunities for other people to participate in the global exchange of goods and services. Take for example a developing nation that has very limited resources and limited capital to develop the land and the people. But thanks to the dynamics of international finance foreign investments will provide funds for the creation of factories and businesses. This will stimulate the local economy and in the long run will transform the global economy because foreign investors will sell the products generated by the said factories and businesses and sell it all over the world and not just for the consumption of the local people.

It is not easy to simplify concepts such international finance and global economy. There are so many factors involve and there are so many components that need to be considered. For instance the exchange rate will cause a particular currency to appreciate or to be devalued and there are various implications. A strong Japanese yen will create a chain reaction of events that will be very difficult to track down and analyze. The same is true when it comes to cross-border financial flows. It is easy to measure the amount of money that moves in and out of a particular but the full extent of the impact of foreign investments and remittances is not easy to grasp. Still it is enough to conclude that international finance and its two major components exchange rate and movement of funds from one country to the next can easily influence the global economy.

Works Cited

Carrasco, Enrique & Jane Ro. Remittances and Development. 2009. Web.

Heakal, Reem. Floating and Fixed Exchange Rates. 2009. Web.

Terril, Roman. Globalization in the 1990s. Web.

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