III. The Foreign Exchange Controversy A. Purchasing Power Parity Theory

The exchange ratio between two different kinds of money tends to correspond to the exchange ratio between each of them and commodities and services. It is usual to call this ratio the static or natural ratio. If this exchange ratio between two kinds of money is disturbed, people will start operations — buying and selling — in order to profit from existing discrepancies. These transactions tend to reestablish the natural ratio.

It does not make any difference whether the two kinds of money are used in the same country simultaneously (as was the case under the old parallel gold and silver standard) or whether each country uses one of them only. The natural rate of foreign exchange is determined by the purchasing power of each of the two kinds of money.

If a payment has to be effected in a distant place, the transaction is burdened with the cost of shipping the money. These costs are avoided if claims and debts of various people in the two places can be cleared. If complete settlement of all payments due can be achieved in this way, no actual shipping of money is required. If an unsettled surplus turns up, it must be settled by transfers from place to place.

The balance of payments does not determine the exchange ratio. It only determines how much of the cost of shipping money can be saved. If the two places or countries in question use the same precious metal as the standard, the balance of payments determines the fluctuations of the rate-of-exchange within the rigid limits set by the cost of shipping money (gold points or shipping points).

B. Balance of Payment Theory

Balance of payment theory asserts that foreign exchange rates are determined by the balance of payments.

This doctrine fails to realize that the amount of foreign trade depends on the structure of prices. If Atlantis imports from Thule a commodity A, for the unit of which two ducats must be paid in Atlantis, the commodity must be sold in Thule at the equivalent of two ducats in its local currency, that is, ten florins. If, without any inflation in Thule, the price of the ducat goes up to three florins, the importation of A must drop or stop altogether because at the price of fifteen florins, the demand for A in Thule shrinks or disappears altogether. A rise of foreign exchange rates that does not correspond to a rise of domestic prices (a fall of the purchasing power of the domestic currency) thus has the tendency to render the country’s balance of payment “favorable.”

But, object the supporters of balance of payment theory, things are certainly different if A is a vital necessity for the citizens of Thule. Then, they must import A, no matter how much its price goes up. This, too, is a fallacy. If the individual citizens of Thule spend more florins for the purchase of A, they must, if there is no domestic inflation, restrict their buying of other commodities, either domestic or imported. In the first case, the prices of these domestic commodities drop, and they become available for export. In the second case, the amount of foreign exchange that would have been absorbed by the importation of other goods becomes available for the purchase of A.

If there is domestic inflation in Thule, then — and only then — a rise of the price of A (in florins) will not hinder the importation of A, as soon as the price of A (in Thule) is affected by the general rise of prices.

C. The Requirements of Foreign Exchange Stability

There is but one means to keep a nation’s domestic currency at par with gold and the sound currency of other countries: to abstain from credit expansion and inflation.