International Trade and the Financial System

Balance of Payments

In the modern world, no economy exists in isolation. Countries trade with each other, invest abroad, and both receive and send out migrants. All these international economic interactions are reflected in the balance of payments—a systematic record of all economic transactions between residents of a given country and the rest of the world over a certain period.

The balance of payments consists of three main parts:

1. Current Account. Reflects trade in goods and services, investment income, and transfers.

Trade balance—exports minus imports of goods. Germany, China, and Japan traditionally have a trade surplus (exporting more than they import). The USA and the UK have a chronic deficit.
Services balance—exports minus imports of services (financial services, tourism, transport, IT). The UK and USA have a surplus in services, offsetting part of the deficit in goods.
Investment income—dividends and interest received from foreign investments, minus payments made to foreign investors.
Current transfers—one-way transfers (aid to developing countries, remittances from migrants sent home).

2. Financial Account. Reflects capital movement: foreign direct investment (FDI), portfolio investment (purchase of stocks and bonds), and bank loans.

3. Capital Account. Includes capital transfers and transactions with non-produced non-financial assets (patents, licenses).

Fundamental identity: current account + financial account + capital account = 0. If a country has a current account deficit (imports more than it exports), it must be financed by a surplus in the financial account (capital inflow from abroad). For example, the USA has a huge current account deficit but attracts even greater capital inflow—foreigners buy US government bonds, stocks, and real estate.

Exchange Rates and Their Determinants

An exchange rate is the price of one currency, expressed in units of another. For example, 1 dollar = 0.82 euro, or 1 pound sterling = 1.27 dollars. The exchange rate is of great importance for international trade: it determines how expensive or cheap foreign goods are for domestic consumers and vice versa.

There are two main systems of exchange rates:

Floating exchange rate—the rate is determined by supply and demand in the currency market. Most major world currencies (dollar, euro, pound, yen) float. Demand for the currency depends on exports (foreigners buy the country's currency to pay for its goods), capital inflow, and speculative operations. Supply of the currency depends on imports (residents sell their currency to purchase foreign goods) and capital outflow.

Fixed exchange rate—the government or central bank sets the rate and maintains it through interventions in the foreign exchange market (buying or selling currency from reserves). The Chinese yuan was long pegged to the US dollar, although China is now gradually moving to a more flexible regime.

Factors Influencing the Exchange Rate:

Interest rates. Higher rates attract foreign capital → demand for the currency rises → the currency strengthens. When the Federal Reserve aggressively raised rates in 2022, the dollar appreciated against most world currencies.
Inflation. High inflation weakens the currency because it reduces export competitiveness and makes foreign goods relatively cheaper.
Trade balance. A trade surplus creates demand for the national currency (foreigners buy it to pay for exports) → currency strengthens.
Economic growth. A fast-growing economy attracts investment → demand for the currency grows.
Political stability. Investors prefer stable countries. A political crisis or change in power can cause capital outflow and currency weakening.
Speculation. The foreign exchange market (Forex) is the largest financial market in the world, with a daily turnover of more than $7 trillion. Speculative operations can cause significant short-term exchange rate fluctuations.

The Link Between International Trade and the Business Cycle

International trade and the business cycle are closely connected through several channels:

Imports and the business cycle. When the economy grows (expansion phase), consumer incomes and expenditures increase, including spending on imported goods. Imports rise, worsening the trade balance. When the economy slows (recession), consumers cut spending, imports fall, and the trade balance improves. Thus, a current account deficit is typical during a boom, and surplus occurs during a recession.

Exports and the global cycle. A country’s export depends on the economic state of its trading partners. If the global economy is in recession, demand for exports falls, which exacerbates the domestic downturn. This explains why the 2008 crisis spread so quickly across the world: a drop in demand in one country led to decreased exports in another → a drop in its GDP → a fall in its imports → decreased exports from a third country, and so on.

Exchange rate and competitiveness. Weakening of the national currency makes exports cheaper and stimulates their growth, while making imports more expensive, thus reducing them. This can help a country get out of recession via “export-led growth.” For example, after the devaluation of the pound sterling as a result of Brexit (2016), British exports became more competitive.

<div style="text-align: center; margin: 20px 0;"> <svg width="100%" style="max-width: 600px;" viewBox="0 0 560 340" xmlns="http://www.w3.org/2000/svg"> <defs> <marker id="m7-ax2" markerWidth="8" markerHeight="6" refX="8" refY="3" orient="auto"> <polygon points="0 0, 8 3, 0 6" fill="#333" /> </marker> </defs> <line x1="40" y1="250" x2="245" y2="250" stroke="#333" stroke-width="1.2" marker-end="url(#m7-ax2)" /> <line x1="40" y1="250" x2="40" y2="45" stroke="#333" stroke-width="1.2" marker-end="url(#m7-ax2)" /> <text x="142" y="278" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle">Good X</text> <text x="18" y="148" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle" transform="rotate(-90, 18, 148)">Good Y</text> <text x="142" y="42" font-family="sans-serif" font-size="12" fill="#1e40af" font-weight="bold" text-anchor="middle">Country A</text> <path d="M 40,70 Q 170,75 220,250" stroke="#2563eb" stroke-width="1.8" fill="none" /> <text x="175" y="105" font-family="sans-serif" font-size="10" fill="#2563eb" font-weight="bold">PPC (A)</text> <path d="M 40,90 Q 200,100 235,250" stroke="#16a34a" stroke-width="1.5" fill="none" stroke-dasharray="6 3" /> <text x="205" y="135" font-family="sans-serif" font-size="9" fill="#16a34a" font-style="italic">With trade</text> <circle cx="160" cy="148" r="3.5" fill="#dc2626" /> <text x="168" y="145" font-family="sans-serif" font-size="9" fill="#dc2626">Without trade</text> <circle cx="195" cy="115" r="3.5" fill="#16a34a" /> <text x="145" y="175" font-family="sans-serif" font-size="9" fill="#555" font-style="italic">Specialization</text> <text x="145" y="188" font-family="sans-serif" font-size="9" fill="#555" font-style="italic">in good X</text> <line x1="310" y1="250" x2="515" y2="250" stroke="#333" stroke-width="1.2" marker-end="url(#m7-ax2)" /> <line x1="310" y1="250" x2="310" y2="45" stroke="#333" stroke-width="1.2" marker-end="url(#m7-ax2)" /> <text x="412" y="278" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle">Good X</text> <text x="288" y="148" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle" transform="rotate(-90, 288, 148)">Good Y</text> <text x="412" y="42" font-family="sans-serif" font-size="12" fill="#991b1b" font-weight="bold" text-anchor="middle">Country B</text> <path d="M 310,70 Q 350,170 410,250" stroke="#dc2626" stroke-width="1.8" fill="none" /> <text x="380" y="120" font-family="sans-serif" font-size="10" fill="#dc2626" font-weight="bold">PPC (B)</text> <path d="M 310,55 Q 365,160 430,250" stroke="#16a34a" stroke-width="1.5" fill="none" stroke-dasharray="6 3" /> <text x="420" y="145" font-family="sans-serif" font-size="9" fill="#16a34a" font-style="italic">With trade</text> <circle cx="365" cy="155" r="3.5" fill="#dc2626" /> <text x="373" y="152" font-family="sans-serif" font-size="9" fill="#dc2626">Without trade</text> <circle cx="355" cy="120" r="3.5" fill="#16a34a" /> <text x="380" y="200" font-family="sans-serif" font-size="9" fill="#555" font-style="italic">Specialization</text> <text x="380" y="213" font-family="sans-serif" font-size="9" fill="#555" font-style="italic">in good Y</text> <text x="280" y="310" font-family="sans-serif" font-size="12" fill="#555" font-style="italic" text-anchor="middle">Fig. 1: Comparative advantage and trade gains</text> <text x="280" y="328" font-family="sans-serif" font-size="10" fill="#777" text-anchor="middle">PPC — production possibility curve</text> </svg> </div>

The Financial System and Financialization

The financial system is the set of institutions, markets, and instruments that provide for the transfer of money from those who save (households, firms) to those who invest (firms, government). It includes banks, stock exchanges, insurance companies, pension funds, investment funds, and other financial intermediaries.

A healthy financial system is a key precondition for economic growth. It transforms savings into investment, distributes risks, and provides the payment system. But when the financial system “breaks down,” the consequences are catastrophic.

The 2008 Global Financial Crisis: A Lesson in Financialization

The 2008 crisis is one of the most instructive examples of how problems in the financial sector can destroy the entire economy. Sequence of events:

1. Real estate bubble. In the 2000s, house prices in the USA rose rapidly. Banks issued mortgage loans to increasingly less reliable borrowers (subprime mortgages)—people without stable incomes and with poor credit history. Why? Because banks did not keep these loans on their books. Instead, they “packaged” them into complex financial instruments (CDOs—collateralized debt obligations) and sold them to investors all around the world.

2. The bubble bursts. When house prices started to fall in 2006−2007, borrowers could not refinance their loans and began to default. The value of CDOs collapsed. Banks and financial institutions holding these instruments suffered huge losses.

3. Systemic crisis. On September 15, 2008, Lehman Brothers—the fourth-largest investment bank in the USA (assets $639 billion)—went bankrupt. This triggered panic: banks stopped lending to each other, financial markets froze, and credit for business and consumers practically vanished.

4. The real economy. The financial crisis rapidly turned into an economic one: without credit, firms could not finance operations, investment collapsed, and consumer confidence plummeted. GDP in advanced countries fell by 3–5%, and unemployment reached double digits in many nations.

5. Government intervention. Governments rescued banks at taxpayers’ expense (bailout), central banks cut rates to zero and “printed” money via QE. These measures prevented a repeat of the Great Depression, but left behind huge public debts and moral hazard.

The lesson of 2008: the financial system is not just a “service sector,” but a key element of the economy, capable of both accelerating growth and causing a devastating crisis. Excessive “financialization” (growth of the financial sector relative to the real economy, the creation of ever more complex and opaque financial instruments) carries systemic risks.

Money: Functions and Evolution

Money is such a familiar part of our lives that we rarely think about what it is and why it works. Yet money is one of humanity’s most important inventions—without it, a complex economy would be impossible.

Functions of Money

1. Medium of Exchange. The main function: money eliminates the need for barter (direct exchange of goods). In a barter economy, you need a “double coincidence of wants” to make an exchange: you have to find someone who (a) has what you need, and (b) wants what you have. Imagine: you’re a baker, and you need shoes. You have to find a cobbler who wants bread. If the cobbler wants fish, you must first exchange bread for fish, and then fish for shoes. Incredibly inefficient. Money solves this problem: you sell bread for money and buy shoes for money—no double coincidence required.

2. Unit of Account. Money allows the value of all goods to be expressed in a single unit, making price comparison possible. Without money, it would be necessary to remember the exchange rate for every pair of goods. If an economy has 100 goods, that’s 4,950 exchange ratios. With money, only 100 prices are needed.

3. Store of Value. Money preserves value over time—you can earn money today and spend it in a month or a year. However, inflation undermines this function: if prices increase by 10% annually, money loses 10% of its purchasing power each year. That’s why in countries with high inflation, people get rid of money as quickly as possible, converting it into real assets (real estate, gold, foreign currency).

4. Standard of Deferred Payment. Money allows contracts with future payments—loans, rental agreements, employment contracts. This is possible only with stable money value.

Historical Evolution of Money

Barter → Commodity money (livestock, shells, salt—from Latin salarium, the origin of the word “salary”) → Metal coins (gold, silver—first in Lydia, 7th century BC) → Paper money (China, 10th century; Europe—from the 17th century) → Bank money (checks, transfers—with the development of banking) → Electronic money (credit and debit cards, since the 1950s) → Digital money (online payments, mobile money, cryptocurrencies—the 21st century).

Each stage of money’s evolution expanded the possibilities for trade and economic growth. The move from commodity to paper money made it possible to create money in the quantity required, not limited by gold reserves. The transition to electronic money accelerated settlements and reduced transaction costs. Mobile money (M-Pesa in Kenya) revolutionized financial access in developing countries, where millions of people had no bank accounts.

Money Supply and Demand for Money

Money supply is the total amount of money circulating in the economy. It includes cash (banknotes and coins), money in current accounts, time deposits, and other liquid assets.

The central bank controls the money supply through several instruments: setting interest rates, open market operations (buying and selling government bonds), and changing reserve requirements for commercial banks.

Demand for money is the desire of economic agents to keep part of their wealth in money form (rather than other assets—stocks, bonds, real estate). There are three motives for holding money (according to Keynes’ classification):

Transaction motive—money is needed for everyday purchases. The larger the income and the higher the price level, the more money is needed for transactions.
Precautionary motive—money is held “for a rainy day”—in case of unforeseen expenses (repairs, medical bills).
Speculative motive—money is held to take advantage of future investment opportunities. If interest rates are high (bond prices are low), people prefer to buy bonds. If rates are low (bond prices are high), people prefer to hold money, waiting for bond prices to fall.

Interest rate is the “price” of money. At higher interest rates, the opportunity cost of holding money (instead of investing in bonds) is higher → demand for money is lower. At lower rates, demand for money is higher.

Macroeconomic Policy and Money

Interest rates affect the cost of borrowing → investment and consumption → aggregate demand. Money supply affects inflation in the long run (quantity theory of money: if the money supply grows faster than real output, the result will be inflation). Financial stability is critical for preventing crises—a painful lesson learned in 2008.

The Connection of All Macroeconomic Topics

All the topics we have studied in this course form a single system. Macroeconomic variables are interconnected, and a change in one triggers a chain reaction:

When economic growth accelerates, unemployment falls (firms hire more workers), but inflation may rise (aggregate demand grows faster than supply), and imports increase (consumers spend more, including on foreign goods), worsening the balance of payments.

When unemployment falls, pressure on wages increases (workers are in short supply), which can lead to cost inflation.

When inflation rises, export competitiveness declines (domestic goods become more expensive), the balance of payments deteriorates, and the central bank raises interest rates, slowing growth and increasing unemployment.

When injections (J) exceed leakages (W), aggregate demand rises, GDP increases, unemployment falls, but inflation may accelerate. When leakages exceed injections, the opposite occurs: demand falls, GDP decreases, unemployment rises, but inflation slows.

These interrelationships show why macroeconomic policy is always an art of balance. It is impossible to maximize growth, minimize unemployment, keep inflation down, and maintain the balance of payments all at once. Governments and central banks are constantly seeking optimal compromises, responding to changing economic conditions.

Course Summary

Microeconomics:

Scarcity generates choice; opportunity cost is the value of the best foregone alternative
Supply and demand determine price and quantity through the price mechanism
PED helps firms make pricing decisions and assess the impact of changes
Costs depend on the production function; MC rises due to diminishing returns
Profit is maximized where MR = MC—a universal rule for all market structures
Market structures (from perfect competition to monopoly) determine prices, profits, and efficiency
Externalities cause market failures; the state may intervene through taxes, subsidies, and regulation

Macroeconomics:

GDP = C + I + G + X − M, measured by three methods, each giving the same result
Business cycle: upswing → expansion → peak → recession, illustrated by real historical crises and recoveries
Circular flow of income: J = W in equilibrium; the multiplier amplifies initial changes in expenditures
Unemployment: disequilibrium (cyclical, due to real wage) and equilibrium (frictional, structural, seasonal)
Inflation: demand-pull (AD rightward), cost-push (AS leftward), expectations (wage-price spiral)
AD/AS model determines price level and real GDP; allows analysis of demand and supply shocks
Macropolicy: fiscal (G, T), monetary (interest rates, QE), supply-side policy (reforms, investment)
International trade: balance of payments, exchange rates, link between trade and the business cycle
Financial system: from barter to digital money; lessons from the 2008 crisis about systemic risks
All macroeconomic variables are interconnected, and policy always requires compromise