On the Manipulation of Money and Credit: Three Treatises on Trade-Cycle Theory

Appendix: Balance of Payments and Foreign Exchange Rates

Appendix Balance of Payments and Foreign Exchange Rates The printing press played an important role in creating the means for carrying on the war. Every belligerent nation and many neutral ones used it. With the cessation of hostilities, however, no halt was called to the money-creating activities of the banks of issue. Previously, notes were printed to finance the war. Today, notes are still being printed, at least in some countries, to satisfy domestic demands of various kinds. The entire world is under the sway of inflation. The prices of all goods and services rise from day to day and no one can say when these increases will come to an end. Inflation today is a general phenomenon, but its magnitude is not the same in every country. The increase in the quantity of money in the different currency areas is neither equal statistically—an equality which, given the different demands for money in the different areas, would be apparent only—nor has the increase proceeded in all areas in the same ratio to the demand for money. Thus, price increases, insofar as they are due to changes from the money side, have not been the same everywhere. . . . Price increases, which are called into existence by an increase in the quantity of money, do not appear overnight. A certain amount of time passes before they appear. The additional quantity of money enters the economy at a certain point. It is only from there, step by step, that it is dispersed. It goes first to certain individuals in the economy only and to certain branches of production. As a result, in the beginning it raises the demand for certain goods and services only, not for all of them. Only later do the prices of other goods and services also rise. Foreign [Excerpted from “zahlungsbilanz und Devisenkurse” in Mitteilungen des Verbandes Oesterreichischer Banken und Bankiers, Vol. 2, #3–4, 1919.—Ed.] 46 • stabilization of the monetary unit exchange quotations, however, are speculative rates of exchange—that is, they arise out of the transactions of business people, who, in their operations, consider not only the present but also potential future developments . Thus, the depreciation of the money becomes apparent relatively soon in the foreign exchange quotations on the Bourse—long before the prices of other goods and services are affected. . . . Now, there is one theory which seeks to explain the formation of foreign exchange rates by the balance of payments, rather than by a currency’s purchasing power. This theory makes a distinction in the depreciation of the money between the decline in the currency’s value on international markets and the reduction in its purchasing power domestically . It maintains that there is only a very slight connection between the two or, as many say, no connection at all. The exchange rate of foreign currencies is a result of the momentary balance of payments. If the payments going abroad rise without a corresponding increase in the payments coming into the country, or if the payments coming from abroad should decline without a corresponding reduction of the payments going out of the country, then foreign exchange rates must rise. We shall not speculate on the reasons why such a theory can be advanced. Between the change in the exchange rates for foreign currencies and the change in the monetary unit’s domestic purchasing power, there is usually a time lag—shorter or longer. Therefore, superficial observation could very easily lead to the conclusion that the two data were independent of one another. We have also heard that the balance of payments is the immediate cause of the daily fluctuations in exchange rates. A theory which explained surface appearances only and did not analyze the situation thoroughly could easily overlook the facts that (a) the day-to-day ratio between the supply of and demand for foreign exchange determined by the balance of payments can evoke only transitory variations from the “static” rate formed by the purchasing power of various kinds of money, (b) these deviations must disappear promptly, and (c) these variations will vanish more quickly and more completely the less restraints are imposed on trade and the freer speculation is. Certainly there shouldn’t be any reason to examine this theory further . It has been settled scientifically. The fact that it plays a significant role in economic policy may be a reason for investigating the political basis for its undoubted popularity among government officials and writers. Still that may be left to...