International Finance

Session 1 — The International Financial System

Laura Contreras-Portela

KEDGE Business School

October 2026

Welcome!

• Laura Contreras-Portela
• 🇨🇴 Economist
• PhD in Economics at Aix-Marseille School of Economics
• My research: international trade, innovation & AI
• Experience working with international organizations and policy-oriented research
• Any questions? Just ask/email me!
  • 📩 Contact me: [laura.contrerasportela@kedgebs.com](mailto:laura.contrerasportela@kedgebs.com (if urgent: laura.contreras-portela@univ-amu.fr

Ground rules

• Every question is a good question
• No phones (try at least)
• Be kind and respectful
• AI is not prohibited — but use it wisely

Main goals of this course

Build a set of operational models of how international financial markets work and understand where they break down: the limitations of theory and the issues they raise.

• Informational efficiency, financial crises, regulation, and behavioural finance — through the analysis of academic papers, connected to real-world cases and applications that have challenged the theoretical foundations of financial economics
• The 2008–2010 financial crisis put key ideas — risk diversification, informational efficiency, and valuation efficiency — into serious question and reshaped the way we think about financial markets
• A second objective — and I mean it — is to think about what a more responsible practice of finance could look like

No textbook. Reference: Mishkin, F.S. & Eakins, S.G. (2008), Financial Markets and Institutions, 7th ed., Pearson.
Course description on LEARN: http://learn.kedgebs.com

Course content

All the course materials can be found here: https://lauradcontreras.github.io/international-finance-kedge/

Session	Topic	Preliminary reading / assignment
1–2	International financial system	Monasterolo (2020), Climate Change and the Financial System, Ann. Rev. Resource Econ. 12
3–4	Securities markets	Sartzetakis (2021), Green bonds as an instrument to finance low carbon transition, Econ. Change & Restructuring 54
5–6	Financial institutions and firms	Muñoz (2020), Board of trustees, financial and sustainable performance of SRI mutual funds, CSR & Env. Mgmt 27(4)
7	Regulation	Individual assignment
8	Security analysis	Group presentation (5 students)
9	Regulation
10	Final examination

Read the paper before the session and bring a calculator!

Evaluation

• Assignment: 20-min quiz, written

• Group work: analysis of a security, groups of 5, 12-minute presentation

• Final exam: individual, written

	Assignment	Group work	Final exam
Weight	20%	40%	40%
When	Session 7 (20 min)	Session 8	Session 10
Documents	Not allowed	Presentation	Allowed

Group work: security analysis

Maximum 5 students per group · 12-minute presentation.

1. What are the characteristics of the security studied?
2. What are the actual and expected situations for that security market?
3. What is the international dimension of this market?
4. What are the risks and opportunities in it?

Push them to pick a security they can get real data on. Groups that choose an exotic derivative spend the whole presentation explaining the instrument and never get to questions 2–4.

Three questions before we start

1 · Where do you see yourself working?

2 · What have you seen before?

3 · How comfortable do you feel with finance and quantitave concepts?

No wrong answers — this helps me choose relevant examples and know where to slow down.

Scan to answer

See live results →

Give them around ninety seconds and actually wait.

Question 1 tells you which examples are most relevant for this cohort.

Question 2 tells you which topics are already familiar and where you may need to slow down.

Question 3 gives you a sense of how much quantitative scaffolding they may need.

Click “See live results” once students have answered.

1 · The International Financial System

OUTLINE

Four prices and one accounting identity. That is the whole session.

1. The financial system — who saves, who borrows, and what sits in between
2. The balance of payments — every euro that crosses the border, written down twice
3. The interest rate — the price of money
4. The exchange rate — the price of a currency, and who pays to defend it
5. Discussion: Monasterolo (2020) — what climate does to all four

Main idea: follow the money.

→ Start with the financial system: who has funds, who needs them, and how they are connected.

→ Then cross borders: how do we keep track of international transactions? → Balance of Payments.

→ Funds also have a price → interest rates.

→ Across countries, we also need the price of currencies → exchange rates.

→ Finally: bring everything together with Monasterolo (2020). What changes when climate risk enters the financial system?

Transition: Let’s start with the most basic question: why do we need a financial system in the first place?

Motivation: Where does your money sleep at night?

You are paid on the 28th. Some of that money stays in your bank account.
But it doesn’t just sit there.

• Your money enters the financial system.
• Someone else needs funds: a firm, government, or household.

Who connects the two?

European Central Bank

Source: Corporate Europe Observatory

New York Stock Market

Source: National Geographic

“Let’s start with something very simple: what happens to your money after you get paid?”

“Imagine you’re paid on the 28th. You spend some of it, but some stays in your bank account.”

→ Reveal: But it doesn’t just sit there.

“Your bank balance is part of a much larger financial system. At the same time, somewhere else, a firm, a government, or another household needs money.”

→ Ask: Who connects the two?

[Pause — let them answer.]

→ Reveal images.

“Broadly, there are two ways of connecting those who have funds with those who need them: through financial intermediaries, such as banks, or through financial markets.”

→ Transition:

“So let’s start by understanding this basic function: how does the financial system move funds from those who have them to those who need them?”

1 · The financial system and the real economy

“Now let’s put the whole picture together.”

→ Start at the top: real economy — households, firms and governments, domestic or foreign.

“All of them receive resources and make expenditures.”

→ Point to Resources − expenditures.

“If resources exceed expenditures, there are funds available. If expenditures exceed resources, there is a financing need.”

→ Point left/right.

“These are not fixed types of agents. A household, firm or government can be on either side.”

→ Move down to financial system.

“The financial system connects these two positions.”

→ Direct finance:

“With direct finance, funds move through financial markets. Those needing finance issue securities such as bonds or shares.”

→ Indirect finance:

“With indirect finance, an intermediary — typically a bank — stands in between: it collects funds and transforms them into loans.”

→ Final message:

“So the basic function is simple: move funds from those who have them to those who need them.”

→ Transition:

“The next question is: what is actually different between these two channels?”

1 · Two ways of channelling savings/funds

Market-based

Financial markets do the allocation of loanable funds. Savers hold securities directly. Prices and investors’ decisions** determine who gets financed and at what price.

Bank-based

Intermediaries allocate the funds. Banks screen, monitor and transform maturity from lenders and savers to borrowers and spenders.

The U.S. and U.K. have traditionally relied more on markets; France and Japan more on banks. Why might this matter? Information, tools, expertise, screening and decision-making.

“We’ve just seen that there are two main ways to move funds from savers to borrowers. Now let’s look at what actually distinguishes them.”

→ Market-based

“In a market-based system, investors decide more directly where their money goes.”

“They buy securities issued by firms or governments, and prices aggregate information and help allocate funds.”

→ Bank-based

“With banks, there is another layer of decision-making.”

“The bank collects funds, but then it screens borrowers, evaluates risk, monitors them, and decides who receives financing.”

→ Ask:

“So why might it matter whether an economy relies more on markets or on banks?”

[Let them answer.]

→ Key point:

“The difference is largely about who produces the information and who makes the allocation decision.”

“Markets rely more on prices and dispersed investors. Banks rely more on internal information, expertise, screening and monitoring.”

→ Transition:

“But if funds are allocated through markets, what actually happens inside a financial market? Let’s open that box.”

1. Financial System: Problem 1.1

• Data
• Answer:

France (EUR bn)	2000	2005	2010	2015	2020	2023	2024
Non-financial corporations	-2.4	5.7	24.0	1.5	-3.3	35.0	37.3
Financial corporations	9.5	27.3	29.7	17.2	6.7	-38.3	-39.4
Public administrations	-19.3	-61.8	-142.8	-85.7	-207.1	-151.7	-168.6
Households	40.9	40.8	82.4	62.7	155.9	123.5	168.8
NPISH	0.4	0.7	0.9	-0.1	3.2	4.6	5.7
Total economy	29.0	12.6	-5.7	-4.5	-44.6	-27.0	3.8

Net lending (+) / net borrowing (−) by institutional sector. NPISH = non-profit institutions serving households.

(a) Which institutional sectors usually run a savings surplus, and which run a deficit?

(b) Why can France be analysed as an open economy?

• Households are the structural surplus sector; public administrations the structural deficit sector.
• Non-financial corporations swing with the cycle — look at 2020 against 2024.
• The total economy line is the country’s net lending to the rest of the world. It is not zero: what closes the gap is the rest of the world.

“Let’s see whether we can identify these surplus and deficit positions in actual data.”

→ Give them a moment to look at the table.

“Positive means the sector has funds available — it is a net lender. Negative means it has a financing need — it is a net borrower.”

→ Ask (a):

“Don’t focus on one particular year. Look for the general pattern across years.”

[Households → usually surplus. Government → usually deficit.]

→ Firms:

“Are firms always borrowers? No. Their position can change quite substantially — compare 2020 and 2024.”

→ Ask (b):

“Now look at the total economy. If France were completely closed, what would you expect?”

“The domestic sectors would have to balance each other. But the total is not zero.”

→ Key point:

“The missing counterpart is the rest of the world.”

“So surplus funds and financing needs do not have to be matched within the same country.”

→ Transition:

“And once funds can cross borders, we are no longer talking only about finance — we are talking about international finance.”

1 · Inside financial markets: an organised architecture

• Issuers raise funds by creating securities in the primary market
• Investors provide funds and can later trade existing securities in the secondary market
• A trade is not complete at execution: it still has to go through clearing and settlement
• The whole process operates within a framework of market regulation

“Now let’s open the financial-market box.”

→ Start with issuers:

“Firms and governments that need financing can issue new securities.”

“That happens in the primary market — this is where new financing is actually raised.”

→ Move to investors:

“Investors provide the funds in exchange for those securities.”

→ Secondary market:

“After that, those securities can be traded between investors.”

“That is the secondary market. The issuer is no longer raising new money — the security is simply changing hands.”

→ Move down:

“But execution is not the end of the transaction.”

“First, clearing determines who owes what to whom.”

“Then settlement is the actual transfer of cash and securities.”

→ Regulation:

“And all of this happens within a regulatory framework.”

→ Transition:

“So a financial market is not just buyers and sellers. It is an entire infrastructure that makes issuance and trading possible.”

“Now let’s see what changes once these transactions cross national borders.”

1 · What changes when we cross borders?

• Foreign exchange and political risk. Cross-border transactions expose firms to currency risk, as well as political risk — from changes in tax or regulatory rules to restrictions on capital flows or expropriation.

• Market imperfections. Crossing borders introduces legal restrictions, transaction and transport costs, information asymmetries and differences in taxation. International markets are therefore not perfectly integrated.

• Expanded opportunity set. At the same time, firms can sell, produce, invest and raise funds across countries and capital markets, while investors can diversify internationally.

The basic financial problem has not changed. What changes is the environment:

\text{More opportunities} \qquad \longleftrightarrow \qquad \text{More risks and frictions}

This is what makes international finance different from purely domestic finance.

“So far, nothing required the saver and the borrower to be in the same country.”

“Now suppose the investor is in France and the firm is in the U.S. What changes?”

→ First: new risks.

“Now the transaction may involve different currencies, so the exchange rate matters.”

“And countries have different governments, regulations and political risks.”

→ Second: more frictions.

“Moving across borders is not frictionless — laws, taxes, information and transaction costs differ across countries.”

→ But there is also an upside.

“Firms are no longer limited to their domestic market. They can sell, produce, invest and raise funds abroad.”

“And investors have many more places to invest and diversify.”

→ Key idea:

“So the fundamental problem hasn’t changed: we still connect funds available with financing needs.”

“But internationally, we have more opportunities — and also more risks and frictions.”

→ Transition:

“Let’s start with one of the simplest ways a firm can go international: trade.”

1 · International trade

The approach

• Firms export to penetrate markets
• Firms import to obtain supplies at low cost

The firms

• Small businesses account for more than 20% of the value of all U.S. exports
• Large MNCs generate a large share of sales from exporting
• Only a subset of firms are able to export: the largest!

Why trade rather than invest

• The firm places none of its capital at risk
• It can stay away from high-risk countries
• It can reduce or discontinue flows easily

Trade is the low-commitment way of being international. The alternative is to move capital — and potentially production — abroad: foreign direct investment (FDI)

“So how can a firm take advantage of these international opportunities?”

“The simplest way is trade.”

→ Exports / imports:

“A firm can sell abroad through exports, or buy inputs and supplies from abroad through imports.”

→ Firms:

“But not every firm trades internationally.”

“Exporting has costs — finding customers, complying with regulations, transportation, distribution — so exporters tend to be larger and more productive firms.”

→ Why trade?

“Trade is relatively low commitment. The firm can access a foreign market without moving its production there.”

“And if conditions change, it is much easier to reduce exports than to close a factory abroad.”

→ Key idea:

“So trade allows firms to become international while keeping most of their capital at home.”

→ Transition:

“But what if exporting is not enough? What if the firm actually wants to produce abroad?”

“Then we move from trade to foreign direct investment — FDI.”

1 · The consequences of free trade

The U.S. has no comparative advantage in shrimp. At the world price of $3 rather than the autarky price of $7:

• domestic production falls to 100
• domestic consumption rises to 900
• imports fill the gap of 800

What happens to the producers and consumers? Who gains, who loses, and by how much? Careful — “the country gains” is not an answer.

World price: $3.0

“Now let’s see what happens when we actually open an economy to trade.”

→ Start at autarky:

“Without trade, the domestic market determines the equilibrium: price is $7 and quantity is 400.”

→ Move the world price to $3:

“Now suppose the U.S. can buy shrimp on the world market for only $3.”

“At this lower price, U.S. consumers want to buy more — but U.S. producers want to produce less.”

→ Point to quantities:

“Domestic production falls to 100, while consumption rises to 900.”

“So where do the remaining 800 come from?”

[Pause.]

“Imports.”

→ Play / move slider:

“And this is the general logic. When the world price is below the domestic autarky price, the country imports.”

“If the world price were above the autarky price, the opposite happens: domestic production exceeds domestic consumption, and the country exports.”

→ Ask:

“So free trade clearly changes prices and quantities. But now comes the more interesting question: who gains and who loses?”

“Consumers pay less. That sounds good. But domestic producers receive a lower price.”

→ Transition:

“To know whether the country as a whole gains, we need to measure both sides — consumer and producer surplus.”

1 · From trade gains to policy bias

The economic result

With a lower world price:

• Consumers gain
• Domestic producers lose
• The country can still experience a net welfare gain

But those gains and losses are not distributed equally.

The political-economy problem

Trade losses are often:

• concentrated in particular firms, workers, or regions
• large and visible for those affected
• easier to organize around politically

Trade gains are often:

• diffuse across many consumers
• individually relatively small
• less politically salient, less incentive to loby

Policy bias

Even when free trade increases aggregate welfare,

\text{political pressure for protection} \;>\; \text{political pressure for free trade} because those who lose have stronger incentives to organize than those who gain.

This creates an international policy bias problem: French producers against US-imports and US producers against French-imports.

“So trade can generate an overall welfare gain. But that doesn’t mean everyone gains.”

→ Consumers:

“Consumers gain from the lower price — but that gain is spread across millions of people.”

“For each individual consumer, the gain may be relatively small.”

→ Producers:

“For domestic producers, the loss can be much larger and much more concentrated.”

“A firm might lose a substantial share of its market. Workers or even entire regions can be affected.”

→ Political economy:

“So who has the stronger incentive to organize, lobby, and put pressure on the government?”

[Pause.]

“Usually, the group facing the concentrated loss.”

→ Policy bias:

“This creates a bias toward protection, even when free trade increases aggregate welfare.”

→ International dimension:

“And the same thing happens on both sides of the border.”

“French producers may ask for protection from U.S. imports, while U.S. producers ask for protection from French imports.”

→ Transition:

“So how can countries escape this political pressure for protection?”

“One solution is to negotiate trade policy together — through international trade agreements.”

1 · The antidotes to the policy bias

• All-or-nothing agreements
• The WTO
• Industries as consumers

In a bilateral or multilateral agreement, two or more countries agree to liberalize trade in many sectors simultaneously.

Bundling can help overcome the protectionist policy bias: import-competing industries seeking protection are counterbalanced by exporters that gain from access to foreign markets.

• 🇪🇺 🇮🇳 EU–India Free Trade Agreement — negotiations concluded in January 2026; proposed for signature in September 2026.

• 🇪🇺 🇦🇷🇧🇷🇵🇾🇺🇾 EU–Mercosur Agreement — signed in January 2026; the interim trade agreement has applied provisionally since 1 May 2026.

Instead of asking:

“Should we protect this industry?”

the political bargain becomes:

“What do we gain abroad in exchange for opening our market at home?”

By setting standards for acceptable and unacceptable trade restrictions, and ruling in specific disputes, the WTO constrains national trade policy.

A government wants to protect a domestic industry from foreign competition. What can it legally do — and what might the WTO prevent it from doing?

• Tariffs: countries generally cannot raise tariffs above the maximum rates they have committed to at the WTO.

• Import quotas: quantitative restrictions on imports are generally prohibited, with specific exceptions.

• Domestic protection: once a foreign product has entered the market, governments generally cannot tax or regulate it less favourably simply because it is imported (National Treatment).

“Consumers” are not only households. A firm that buys a product as an input is also a consumer.

When imported inputs are an important part of production costs, downstream firms may lobby for free trade — and against protection for upstream industries.

• Upstream producers compete with imports → may lobby for protection.

• Downstream firms use those goods as inputs → may lobby against protection.

• The larger the input’s share in their costs, the stronger their incentive to oppose tariffs or other trade barriers.

Example — U.S.–China textiles, 2004

The U.S. textile industry pushed the Bush administration to restrict rapidly growing imports from China.

But clothing retailers and importers opposed new barriers because cheaper imported clothing benefited their businesses.

Same trade policy → competing interests across industries.

“We’ve seen why governments can face pressure to protect domestic producers. So what can reduce this policy bias?”

→ All-or-nothing agreements

“One solution is to negotiate many sectors at the same time.”

“Now the government doesn’t only hear from firms threatened by imports. It also hears from exporters that want access to the other country’s market.”

“So we create a political constituency for trade.”

→ Examples:

“Think about the EU–India or EU–Mercosur agreements: many sectors and interests are negotiated together.”

“The question changes from ‘should I protect my industry?’ to ‘what do we get in exchange for opening our market?’”

→ WTO

“A second mechanism is to constrain what governments can do.”

“Countries make commitments: for example, they cannot simply raise tariffs or introduce quotas whenever domestic political pressure increases.”

“So the WTO makes protection politically and legally more difficult.”

→ Industries as consumers

“And there is a third force that can work against protection: firms themselves can be consumers.”

“If I produce cars, steel is one of my inputs. A tariff protecting domestic steel producers can make my production more expensive.”

→ Example:

“This is why industries can lobby on opposite sides of exactly the same trade policy.”

→ Key takeaway:

“So there are several counterweights to the protectionist bias: exporters, international commitments, and downstream firms that benefit from cheaper imports.”

→ Transition:

“So far we’ve focused mainly on firms crossing borders through trade. But firms can go further: instead of exporting from home, they can move capital and production abroad.”

“That brings us to foreign direct investment.”

2 · The Balance of Payments

Motivation: Ireland exports a lot — but who receives the income?

In 2024, Ireland recorded a goods trade surplus of about €177 bn and a primary income deficit of about €129 bn.

What does that mean?

• Many multinational firms produce and export from Ireland

• But much of the capital behind those firms is owned by foreign investors

• The profits generated in Ireland therefore do not necessarily belong to Irish residents

• Part of the income generated by those exports ultimately flows back to foreign owners

So if €177 bn comes in through trade, while large amounts of income flow back out to foreign owners…

How do we keep track of all these flows?

That is what the Balance of Payments does:

it records the economic transactions between a country’s residents and the rest of the world.

“Now we move from why transactions cross borders to how we record them.”

→ Start with Ireland:

“Ireland is a really interesting example because it exports an enormous amount relative to the size of its economy.”

“In 2024, its goods surplus was around €177 billion.”

→ Reveal primary income:

“But at the same time, Ireland had a primary income deficit of around €129 billion.”

“So how can both things be true?”

→ Multinationals:

“Many multinational firms produce in Ireland and export from there.”

“But producing in Ireland doesn’t necessarily mean that the firm is Irish-owned.”

“If the owners are abroad, part of the income generated in Ireland ultimately accrues to those foreign owners.”

→ Ask:

“So we have goods crossing borders, payments coming in, and income flowing back out.”

“How do we keep track of all of this?”

→ Reveal:

“That’s exactly the purpose of the Balance of Payments.”

→ Transition:

“Let’s start with the basic rules of this accounting system.”

2 · The basics

The Balance of Payments (BoP) records a country’s transactions with the rest of the world over a given period. It helps us understand:

• the demand for and supply of a country’s currency: e.g. a U.S. buyer paying for French wine creates demand for euros

• the country’s relationship with foreign investors and trading partners: e.g. how much foreign investment is flowing into France?

• how the country is performing in the international economy: e.g. is it exporting more than it imports?

Every international transaction has two sides: a credit and a debit.

• Credit (+) → a receipt from foreigners

• Debit (−) → a payment to foreigners

There are three broad types of international transactions:

• Current account → goods, services and income: exports and imports

• Financial flows → purchases and sales of assets: a foreign investor buys French shares

• Official reserves → transactions by the central bank: buying or selling foreign-currency reserves

“So the Balance of Payments is basically a record of everything that happens economically between residents and the rest of the world.”

→ Why do we care?

“It tells us about trade, international investment, and also the demand and supply of currencies.”

→ Credit / debit:

“The basic rule is that every international transaction has two sides.”

“A credit is a receipt from abroad. A debit is a payment abroad.”

→ Give a quick example:

“If France exports wine to the U.S., France receives a payment from abroad — that’s a credit.”

“But remember: that transaction must have another side. We’ll come back to that.”

→ Three types:

“For now, I just want you to keep three big categories in mind.”

“First, the current account: goods, services and income.”

“Second, financial flows: buying and selling assets across borders.”

“And third, official reserves: transactions involving the central bank.”

→ Transition:

“Let’s start with the part that is probably the most intuitive: the current account.”

2 · The current account, BCA

The current account records transactions in goods, services, and income between residents of a country and the rest of the world.

• Trade in goods and services — exports and imports of goods and services, including transport, travel, finance, consulting and insurance. Their balance is the trade balance

• Primary income (factor income) — compensation of employees and income associated with cross-border ownership of financial assets.

• Secondary income (unilateral transfers) — transfers between residents and non-residents for which no good, service or asset is provided in return.
  Example: workers’ remittances, international aid, grants and gifts.

The current-account balance can be summarized as

BCA = \text{Trade balance} + \text{Net primary income} + \text{Net secondary income}

where the trade balance includes both goods and services.

“The current account is the part of the Balance of Payments that records trade and income flows.”

→ Trade:

“First, goods and services. If France exports something, that’s a credit; if France imports something, that’s a debit.”

“The difference between exports and imports gives us the trade balance.”

→ Primary income:

“Then we have income earned because you work or own assets across borders.”

“Think about dividends, interest, profits, or wages.”

→ Connect to Ireland:

“This is exactly what we saw with Ireland: huge exports, but also large income payments to foreign owners.”

→ Secondary income:

“Finally, transfers where nothing is received directly in exchange — remittances, aid, gifts.”

→ Formula:

“So the current account puts these three pieces together: trade + primary income + secondary income.”

→ Transition:

“But the current account is not fixed. Trade flows in particular respond to prices, income — and importantly, to the exchange rate.”

2 · What can change the current account?

The current-account balance is not fixed. It responds to changes in the domestic and international economy.

• Domestic and foreign income affect demand for imports and exports.
• Relative prices affect the competitiveness of domestic and foreign goods.
• The exchange rate can change those relative prices.

Suppose the domestic currency depreciates.

Exports become relatively cheaper abroad and imports become more expensive at home.

Should the trade balance improve?

“So what determines whether the current account moves into surplus or deficit?”

→ Income:

“If domestic income rises, people and firms tend to buy more — including more imports.”

“And if income rises abroad, foreigners may demand more of our exports.”

→ Relative prices:

“Trade also depends on how expensive our goods are relative to foreign goods.”

→ Exchange rate:

“And one thing that can change those relative prices is the exchange rate.”

→ Ask:

“Suppose our currency depreciates — what would you expect?”

“Exports become cheaper for foreigners, while imports become more expensive for us.”

“So our first intuition is: exports up, imports down, trade balance improves.”

[Pause.]

“But does that happen immediately?”

→ Transition:

“Not necessarily — because prices can change immediately, while quantities take time to adjust.”

“That brings us to the J-curve.”

2 · The J-curve

Following a currency depreciation, the trade balance may initially deteriorate before improving over time.

• Prices adjust faster than quantities. Imports become more expensive immediately, while trade volumes respond only gradually.

• Existing contracts, orders and consumption patterns slow the adjustment of import and export quantities.

• Over time, import demand falls and export demand rises.

• The magnitude of the adjustment depends on the price elasticities of exports and imports.

“Now we can answer the question from the previous slide: does a depreciation immediately improve the trade balance?”

“Not necessarily.”

→ Short run:

“Import prices rise quickly, but firms and consumers cannot instantly change what they buy.”

“Contracts, existing orders, and habits mean quantities adjust slowly.”

“So initially, the price effect can dominate — the import bill rises and the trade balance can actually get worse.”

→ Longer run:

“Over time, people substitute away from expensive imports and foreign demand for our exports increases.”

“Then the quantity effect becomes stronger.”

→ Point to the J-shape:

“That is why we can get this J-shaped path: first deterioration, then improvement.”

→ Elasticities:

“How strong the recovery is depends on how responsive exports and imports are to price changes.”

→ Transition:

“So the current account can react to exchange-rate movements — but the Balance of Payments records much more than trade.”

“Next, we move to cross-border asset transactions.”

2 · The capital and financial accounts, BKA

While the current account records flows of goods, services and income, these accounts record transactions involving assets and liabilities.

• Capital account — transactions involving non-produced, non-financial assets and capital transfers.
  Examples: rights to natural resources, licenses, trademarks, or debt forgiveness.

• Foreign direct investment (FDI) — cross-border investment involving a lasting interest or significant influence in a firm.
  A common statistical threshold is ownership of at least 10% of voting power.

• Portfolio investment — cross-border purchases and sales of equity and debt securities that do not qualify as direct investment.
  Examples: foreign shares and government or corporate bonds.

• Financial derivatives — cross-border positions in instruments such as options, futures and swaps.

• Other investment — financial transactions not included above.
  Examples: bank deposits, loans and trade credit.

The distinction is simple:

Current account → flows of goods, services and income
Capital & financial accounts → flows associated with assets and liabilities

“We’ve looked at goods, services and income. But countries also exchange assets.”

→ Capital account:

“The capital account is actually quite small in most countries.”

“It includes things like transfers of ownership of certain non-financial assets or debt forgiveness.”

→ Financial account:

“The big part is the financial account.”

→ FDI:

“FDI means more than simply buying shares — it implies a lasting interest or significant influence in the firm.”

“Statistically, 10% of voting power is the usual threshold.”

→ Portfolio investment:

“Below that, investments in shares and bonds are generally classified as portfolio investment.”

“So the key distinction is influence or control versus financial investment.”

→ Other flows:

“And then we have derivatives, bank loans, deposits, trade credit, and other financial transactions.”

→ Key idea:

“So keep the distinction simple: the current account is about goods, services and income; the capital and financial accounts are about assets and liabilities.”

→ Transition:

“But there is one important player we haven’t discussed yet: the central bank.”

“It can also transact with the rest of the world through its official reserves.”

2 · The official reserve account, BRA

Official reserves are foreign assets held by a country’s central bank or monetary authority.

• They include foreign currencies, foreign securities, gold and other reserve assets.

• When a country faces an international payments deficit, the central bank can sell reserve assets to provide foreign currency.

• When it faces an international payments surplus, the central bank can accumulate reserve assets.

Official reserves can absorb imbalances in international payments:

\text{Deficit} \rightarrow \text{reserves fall} \qquad\qquad \text{Surplus} \rightarrow \text{reserves rise}

“Finally, the central bank can also interact with the rest of the world.”

→ Reserves:

“Central banks hold foreign assets — foreign currencies, securities, and gold.”

“Think of reserves as a buffer that can be used when international payments don’t match.”

→ Deficit:

“If more foreign currency is needed than is coming in, the central bank can sell some of its reserves.”

“So reserves fall.”

→ Surplus:

“If there is excess foreign currency coming in, the central bank can buy it and accumulate reserves.”

“So reserves rise.”

→ Key idea:

“The important intuition is that reserves can help absorb an imbalance between international payments.”

→ Transition:

“Now we have all the pieces: the current account, the capital and financial accounts, and official reserves.”

“So how do they all fit together?”

2 · The Balance of Payments identity

We now have the three components needed to account for a country’s transactions with the rest of the world.

• BCA — current-account balance
• BKA — capital and financial-account balance
• BRA — official reserve balance

Because international transactions are recorded using double-entry accounting,

\boxed{BCA + BKA + BRA = 0}

The Balance of Payments therefore always balances as an accounting identity.

Without reserve intervention

BRA = 0 \quad\Rightarrow\quad BCA = -BKA

With reserve intervention

BRA \neq 0

Reserve transactions help offset the remaining balance.

So when we say that a country has a current-account deficit, does that mean its Balance of Payments is “in deficit”?

“Now we can put all the pieces together.”

→ Identity:

“The key idea is double-entry accounting: every international transaction has a counterpart.”

“So when we add all the accounts together, the Balance of Payments must balance.”

→ No reserve intervention:

“If the central bank does not intervene, a current-account deficit has to be matched by the corresponding financial flows.”

“In simple terms: if a country spends more abroad than it receives through the current account, that difference has to be financed.”

→ With reserves:

“The central bank can also use its reserves, so reserves can absorb part of the imbalance.”

→ Ask:

“So if France has a current-account deficit, can we say that its Balance of Payments is in deficit?”

[Pause.]

“No. The current account can be in deficit, but the Balance of Payments as a whole balances by construction.”

→ Transition:

“Let’s now look at actual data and see whether we can identify these relationships in practice.”

2 · Problem 1.2 — the Balance of Payments of France

• Data
• Questions

Balance of payments (EUR m)	2021 credits	2021 debits	2021 balance	2022 credits	2022 debits	2022 balance
1. Current account	1 217 059	1 207 192	9 867	1 305 182	1 361 853	-56 671
1.1. Goods	622 099	701 546	-79 447	669 608	813 875	-144 267
1.2. Services	303 452	262 453	40 999	343 419	288 781	54 638
1.3. Income	236 992	139 916	97 076	245 451	164 373	81 078
1.4. Current transfers	54 516	103 277	-48 761	46 704	94 824	-48 120
2. Capital account	11 819	485	11 334	12 510	1 196	11 314
3. Financial account	570 363	592 038	-21 675	646 671	708 366	-61 695
3.1. Direct investment	108 891	95 865	13 026	118 759	105 425	13 334
3.2. Portfolio investment	144 062	122 206	21 856	35 326	155 737	-120 411
3.3. Financial derivatives	152 737	132 013	20 724	248 775	291 755	-42 980
3.4. Other investment	164 673	241 954	-77 281	243 811	155 449	88 362
4. Net errors and omissions			-15 866			-14 661
5. Reserve assets	27 009		27 009	1 677		1 677

(a) How did France’s external position change between 2021 and 2022?

Which components of the current account explain the change?

(b) How was France’s 2022 current-account deficit financed?

Look at the financial account and reserve transactions.

(c) Does the Balance of Payments identity hold?

BCA + BKA + BRA = 0 \; ?

If not exactly, what accounts for the difference?

Remember

• Assets → residents’ transactions in securities issued by non-residents
• Liabilities → non-residents’ transactions in securities issued by residents

“Now let’s apply this to France.”

→ Give them a few minutes to work through the questions.

“For part (a), start with the current account. Don’t look at every number — first compare 2021 and 2022.”

“What changed? And then ask: which component is driving that change?”

→ If needed:

“Look particularly at the balance in goods, services, and income.”

→ Part (b):

“Then ask how the 2022 current-account deficit was financed.”

“If the current account is negative, there must be a counterpart somewhere else in the Balance of Payments.”

“Look at the financial account and reserve transactions.”

→ Part (c):

“Finally, test the accounting identity.”

“Do the numbers add exactly to zero?”

“If they don’t, that doesn’t mean the theory is wrong.”

“In real data, we can have errors and omissions because international transactions are measured from different sources and are not recorded perfectly.”

→ Reminder:

“And be careful with assets and liabilities.”

“Assets are French residents’ positions abroad; liabilities are foreigners’ positions in France.”

→ Transition:

“Once we’ve worked through France, we’ll compare it with other European economies and see how different their external positions can look.”

2 · Ireland in the European context — current account

Ireland stands out because of the scale of its exports — and the income that subsequently flows abroad.

Country	Current account	Goods	Services	Primary income	Secondary income	Capital account
EU	493.5	384.1	191.1	28.4	-110.4	-34.9
Euro area	425.9	371.9	169.0	53.6	-168.5	6.3
Germany	246.7	235.5	-74.0	149.0	-63.8	-20.4
France	11.6	-58.1	55.1	61.8	-47.2	5.9
Italy	24.8	64.0	-7.0	-15.8	-16.4	-0.6
Spain	48.1	-32.3	100.4	-8.1	-11.8	18.5
Netherlands	112.7	99.0	38.2	-15.8	-8.6	-3.4
Ireland	91.5	176.6	48.5	-129.0	-4.6	-18.2
Poland	1.7	-6.4	40.2	-28.5	-3.7	2.3

Focus on Ireland

In 2024, Ireland recorded:

\text{Goods balance: } +€176.6\text{ bn} \qquad \text{Primary income: } -€129.0\text{ bn}

How can a country export so much while simultaneously sending so much income abroad?

€ billion. Selected economies. Source: Eurostat, Main components of the current account balance and the capital account balance, 2024.

“Let’s come back to Ireland, now that we understand the current account.”

→ Compare countries:

“First, notice how unusual Ireland is.”

“It has a goods surplus of almost €177 billion — larger than Germany’s relative to the size of the economy, and very different from France.”

→ But primary income:

“Now look at primary income: minus €129 billion.”

“This is the other side of the story we started with.”

→ Ask:

“How can Ireland export so much and, at the same time, send so much income abroad?”

[Pause.]

→ Explanation:

“Because where production takes place and who owns the capital are two different things.”

“Many multinational firms produce and export from Ireland, but their owners and investors can be located abroad.”

“So Ireland records the exports, while part of the income generated by that production accrues to foreign owners.”

→ Key point:

“This is why looking only at the trade balance can give us a very incomplete picture of a country’s external position.”

→ Transition:

“And Ireland is not only deeply integrated through trade. It is also deeply integrated through international financial flows.”

2 · Ireland in the European context — financial account

Ireland’s current account reflects its role in global production. Its financial account reveals another dimension of the same international integration.

Country	Financial account, net	Direct inv., assets	Direct inv., liab.	Portfolio inv., assets	Portfolio inv., liab.	Reserve assets
EU	591.6	190.4	-117.9	641.9	769.6	45.5
Euro area	491.8	196.5	-49.1	734.0	848.4	4.6
Germany	239.4	73.8	43.4	219.8	188.4	-1.4
France	-21.9	43.5	51.6	240.9	259.9	1.4
Italy	51.0	31.5	20.1	93.2	166.9	2.1
Spain	69.8	48.4	29.8	90.7	87.8	1.3
Netherlands	105.8	11.2	-13.0	64.3	4.9	-0.7
Ireland	83.1	62.7	3.7	443.6	391.5	-0.1
Poland	-6.3	7.2	17.0	13.4	23.7	27.2

Focus on Ireland

Ireland also records exceptionally large cross-border portfolio investment assets and liabilities.

What does this tell us about Ireland’s role in the international financial system?

€ billion. Selected economies. Source: Eurostat, Main components of the financial account balance with the rest of the world, 2024.

“Now let’s look at the other side of Ireland’s international integration: financial flows.”

→ Focus on portfolio investment:

“Look at the scale of Ireland’s portfolio assets and liabilities.”

“Irish residents hold more than €440 billion in additional foreign portfolio assets, while foreign investors hold almost €392 billion in additional Irish portfolio liabilities.”

→ Interpretation:

“So Ireland is not simply exporting goods. It is also a major location through which international capital moves.”

→ Connect assets and liabilities:

“Large assets mean residents and institutions in Ireland are investing heavily abroad.”

“Large liabilities mean foreign investors are also investing heavily in assets issued by residents in Ireland.”

→ Key point:

“So we see very large financial flows in both directions.”

“This tells us that Ireland is exceptionally integrated into global financial markets.”

→ Connect both slides:

“And this helps us understand the bigger picture: Ireland is deeply integrated internationally through production, trade, ownership, and finance.”

→ Transition:

“So far we’ve been looking at the quantities that move across borders.”

“But financial decisions also depend on a crucial price: the price of borrowing money.”

“That brings us to interest rates.”

Next class

First hour · Finishing the foundations

If you want to read ahead, you can go through the remaining slides from today’s lecture.

Next class, we will spend the first hour on:

• Interest rates
• Exchange rates
• Their role in international financial markets

Second part · Climate change and finance

We will discuss:

Monasterolo, I. (2020)
Climate Change and the Financial System,
Annual Review of Resource Economics, 12.

Please start reading the paper before class.

As you read, think about…

• Why might investors’ decisions be misaligned with climate risks?
• What are the main climate-related financial risks?
• How can climate policy and regulation create risks for financial assets?
• Why is assessing and pricing climate risk particularly challenging?
• What would good practices for investors, financial institutions and regulators look like?

Come prepared to discuss — I will ask questions!