What is International Finance?

International finance is the branch of economics that studies financial interactions between nations. The areas of study include capital flows from nation to nation, fluctuations in exchange rates, trade balances, effects of tax policies, and other related issues. Modern international finance theory focuses on the broad picture, macroeconomic concepts rather than the fine details of microeconomic approaches. Applications of international finance are often in detailed aspects such as global futures, options, and forex markets.

British moral philosopher Adam Smith published the seminal work in economics, The Wealth of Nations, in 1776. As he recognized in his book, international trade, facilitated by international finance, had been part of the fabric of daily life for more than 2,000 years. The primary instrument of finance was the letter of credit. The ultimate coin of settlement was gold, a tradition that carried into the 20th century.

By the end of the 19th century, most nations in the West had established currency other than gold or silver, with the provision that the currency was redeemable in those metals at a fixed price. Fixed relationships to gold allowed central banks to provide liquidity to their member banks for letters of credit or foreign specie, i.e., currency. That improvement in international finance greatly increased international trade. World War I disrupted the fixed relationships of currency to gold. Central bankers' attempts to return to the pre-war ratios of currencies to gold is considered to be a major factor leading to the Great Depression of the 1930s.

The 1944 Bretton Woods conference set the US Dollar as the reserve currency for the nations of the West. Under that agreement, the US Dollar had a fixed relationship to gold and all other currencies had a fixed relationship to the dollar. In 1971, President Richard Nixon declared the US would no longer maintain a fixed ratio between gold and the US Dollar, freeing it to float against other currencies as the international finance market saw fit.

Since then, currencies have become the most broadly traded item in the markets, with more than $1 trillion US Dollars of currency traded each day they are open. Trading in futures on grains, US Treasury issues, English Treasury issues, crude oil and many of the world's stock markets are now an integral part of international finance. Throughout all the changes, the letter of credit has survived and remains an important and widely used instrument for financing international trade.