Study Guide to the Theory of Money and Credit
10. The Exchange Ratio Between Money of Different Kinds
Chapter Outline
1. The Two-fold Possibility of the Coexistence of Different Kinds of Money
If the inhabitants of one country exclusively use a certain money (such as gold) for their domestic purchases, while a second country uses a different money (such as silver) for their domestic purchases, and the two countries are closely tied economically through trade, then it is incorrect to say that gold is the only common medium of exchange in the first country, and silver the only one in the second country. On the contrary, because merchants from one country can only trade goods with the other country’s merchants through the use of the other domestic money, it is clear that both monies are media of exchange among people in both countries.
2. The Static or Natural Exchange Ratio between Different Kinds of Money
Whether two different monies operate side by side in the same country under a parallel standard, or whether one money is used exclusively for domestic trade in one country while the other money is likewise used in a second country, the same principle operates to regulate the exchange ratio (or what nowadays would be called the exchange rate) between the two monies. The theory of purchasing power parity says that the exchange ratio between two monies is determined by the respective exchange ratios of each money and other goods and services.
For example, if the price of a barrel of crude oil, measured in American dollars, is $100, while the price of a barrel of crude oil quoted in Japan is ¥8,000, then the exchange rate between the two currencies must be $1 for ¥80. If the exchange rate were different, there would be arbitrage opportunities for buying oil with one currency and selling it for the other. For example, suppose the exchange rate were $1 for ¥90 (rather than the equilibrium price of $1 for ¥80). In that case, a Japanese investor could take ¥8,000 and buy a barrel of crude oil. Then he could sell the oil to an American for $100. Finally he could go to the foreign exchange market and trade his $100 for ¥9,000. Thus the Japanese investor would have taken advantage of the existing price ratios to effortlessly turn his original ¥8,000 into ¥9,000. (His efforts to profit from this arbitrage opportunity would eventually eliminate it, since he would be acting to push up the yen-price of oil, push down the dollar-price of oil, and push down the yen-price of a dollar bill.)
If we first imagine a unified region using a single money, with no institutional obstacles to trade among its inhabitants, then it is clear that all commodities, including money, will be distributed among the population in accordance with marginal utility. If some people end up holding an above-average amount of (say) blankets, it is because their demand for this good is higher than average. By the same token, if some people acquire larger cash balances than others, it is because their demand to hold money is larger. There is no question of a dangerous “trade deficit” that could cause a “drain of money” from some people to others.
The same principles hold for nations. The aggregate figures of imports and exports are simply the summation of the trading activities between the individuals in each country. An accumulation of money in one country versus another can only be sustainable if the demand to hold money increases in the first country relative to the second. A trade deficit not accompanied by such a shift in the demand for money will be quickly self-reversing, as the prices in the country accumulating money will rise and the prices in the country losing money will fall.
Technical Notes
• Mises argues on pages 179–80 that even in cases where the consumers in two different countries use different monies in everyday transactions, nonetheless if the regions are closely bound by international trade, then “from the economic point of view both [monies] must be regarded as money for each area.” Updating to our times, what Mises has in mind is that the American businessman who wants to import cars from Japan, must at some point in the transaction exchange dollars for yen or vice versa. In that respect, the yen is a medium of exchange that is accepted in trade by the American businessman, in addition to all of the Japanese. However, it is still not obvious that this should mean that the yen is money even in the United States, because the definition of money is “a commonly accepted medium of exchange.” To be sure, the yen is commonly accepted among Americans doing business with Japan, but it is not commonly accepted in the United States per se. However, the important point is not whether we say that the yen is money in the United States, but rather that we understand Mises’s point that international trade requires businesspeople to accept the monies used in foreign lands.
• On page 182 Mises writes, “[Classical political economy] demonstrated that international movements of money are not consequences of the state of trade; that they constitute not the effect, but the cause, of a favourable or unfavourable trade-balance.” He has in mind the following contrast in analysis: Suppose the English spend one million gold ounces importing wine from France, while the French spend only 900,000 gold ounces importing sweaters from England. An English mercantilist would probably bemoan the fact that his countrymen were importing more than they were exporting, and that this “unfavorable trade balance” was unwittingly losing 100,000 ounces of gold to the dastardly French. However, the classical economists such as Hume, Smith, and Ricardo could point out that the French (in the aggregate) apparently desired to increase their holdings of gold, while the English apparently desired to reduce their holdings. In that case, the only way to satisfy these shifts in money demand would be for the French to ship the English 100,000 gold ounces worth of goods, for which the English would not ship any (nonmonetary) goods in return.
New Terminology
Parallel Standard: A monetary system in which two different goods both serve as monies. (For example, gold and silver might both serve as money under a Parallel Standard.)
Exchange rate: The ratio at which one currency trades against another in the foreign-exchange market.
Purchasing Power Parity: The theory stating that the exchange ratio between two monies is determined by the respective exchange ratios of each money and other goods and services.
Study Questions
1. When England operated on a gold standard, while Germany operated on a silver standard, does Mises think that silver should have been considered as money even in England? (pp. 179–80)
2. How does the doctrine of purchasing power parity explain the exchange ratio between gold and silver in the example of cloth and wheat? (p. 181)
3. Explain: “If no other relations than those of barter exist between the inhabitants of two areas, then balances in favor of one party or the other cannot arise.” (p. 182)
4. What was the train of thought that Mises says “dealt the Mercantilist Theory its death-blow”? (p. 182)
5. Explain: “[I]nternational movements of money, so far as they are not of a transient nature and consequently soon rendered ineffective by movements in the contrary direction, are always called forth by variations in the demand for money.” (p. 185)
