Theories In International Finance

International Finance has some important theories like Purchasing Power Parity (PPP) theory, Mundell-Fleming Model and the Optimum Currency Area (OCA) theory. One of the most popular and controversial theories in international finance is the purchasing power parity (PPP) theory, which attempts to quantify the inflation- exchange rate relationship. The change in the purchasing power of currency will be reflected in the exchange rate.

Second popular theory in international finance is Mundell-Fleming Model. This is a Keynesian model where goods prices are fixed for the duration of the analysis.  The home country is small in the sense that it takes foreign variables as fixed.  There are three determinants of the demand for domestic goods.  First, expenditure depends positively on own income through the absorption channel.  An increase in income leads to higher consumption, most of which is spent on domestically produced goods.  Second, domestic goods demand depends negatively on the interest rates through the investment saving channel.  Higher interest rate reduces investment spending and may encourage a reduction of consumption and on increase in saving. Third, an increase in the real exchange rate coves the price of domestic goods relation to foreign goods, leading expenditure by residents of the home country as well as resident of the rest of the world to switch towards domestically produced goods.

Optimum Currency Area theory can be defined as geographic domain adopting a common currency – respectively keeping exchange rates between different currencies irrevocably fixed.  Such an area can be seen as optimal by being sufficient similar, so that a flexible nominal exchange rate is no longer necessary to support adjustment after a shock was hitting the members. According to Optimum Currency Area theory a high degree of business cycle synchronization might be a key criterion for building a successful monetary union.  A common policy will be earlier to implement if the member countries cycles are aligned.