WEBVTT NOTE A Note on the Austrian Theory of Foreign Exchange Rates 1 00:00:00.000 --> 00:00:11.000 Since my topic is only foreign exchange rates, maybe in the beginning I should clarify what we mean by foreign exchange rate. 2 00:00:11.000 --> 00:00:18.000 And the thing is that foreign exchange rate is the price of one currency in terms of another currency. 3 00:00:18.000 --> 00:00:29.000 Now, another question is what did Austrians say or what have they said about the foreign exchange rate theory? 4 00:00:29.000 --> 00:00:57.000 And the answer is that there hasn't been much done. In fact, there are probably, at most, two clear, genuine contributions to the theory of foreign exchange rates, which is Mises's theory of money and credit and Hayek's monetary nationalism and international stability, published in 1937. 5 00:00:57.000 --> 00:01:05.880 As you see, it's a long time ago, like, since something, at least apparently something genuine 6 00:01:05.880 --> 00:01:13.360 was written on the Austrian, or on the foreign exchange rate theory within the Austrian camp. 7 00:01:13.360 --> 00:01:19.180 And of course I'm not saying that there hasn't been written anything at all after this, but 8 00:01:19.180 --> 00:01:24.720 that mostly these were just re-statements of the argument mostly presented in Mises's 9 00:01:24.720 --> 00:01:52.720 No, but one of these or his statements which was or in fact these were two papers written by Professor Salerno in 1994 are interesting because although from the from like maybe maybe on the first reading it might it might appear that 10 00:01:52.720 --> 00:02:15.720 It might appear that he's just trying again to restate Mises' arguments, but in the end, at least for me, it comes out that, in fact, he's coming with his own exchange rate theory, at least in respect with the equilibrium exchange rate theory that is related with absolute purchasing power parities. 11 00:02:15.720 --> 00:02:35.720 Now, I argue in my paper that this theory is really genuinely written or created by Professor Salerno, and then in fact it is not Misesian. 12 00:02:35.720 --> 00:02:41.720 But I don't want to go much into detail into this, I want to get to the theory itself. 13 00:02:41.720 --> 00:03:01.000 Professor Salerno is trying to present the Misesian theory as he sees it in a way that 14 00:03:01.000 --> 00:03:06.120 encounters it with Castle's Absolute Purchasing Power Parity theory. 15 00:03:06.120 --> 00:03:11.680 But if you read Mises' theory of money and credit, there is like just after the exposition 16 00:03:11.680 --> 00:03:17.480 of the theory of this equilibrium theory of foreign exchange rates, he just has a quote 17 00:03:17.480 --> 00:03:22.120 where he says that, well, and this is exactly what Gustav Kassel is saying and calls it 18 00:03:22.120 --> 00:03:25.120 absolute purchasing power parity. 19 00:03:25.120 --> 00:03:34.920 But let me get to the very theory itself, which is, yeah, it is type of absolute purchasing 20 00:03:34.920 --> 00:03:41.780 Purchasing Power Parity Theory. Now, what does it mean or what it says? Let me clarify 21 00:03:41.780 --> 00:04:02.380 this on the example and try to contrast what Professor Sal 22 00:04:02.380 --> 00:04:23.380 So, let's say that we have two places, New York, London. 23 00:04:23.380 --> 00:04:31.620 Let's say that we have two currencies, dollars, pounds. 24 00:04:31.620 --> 00:04:40.620 And let's say, let's consider one good, one physically same good that is in both of the places, which is Apple. 25 00:04:43.620 --> 00:04:55.620 Now, let's first discuss the Cassellian case. Let's say that the price of Apple in New York is $6. 26 00:04:55.620 --> 00:05:07.020 And let's say that the price of apple in London is £2. 27 00:05:07.020 --> 00:05:14.860 Now the Castellian theory based on the absolute purchasing power parity says that there is 28 00:05:14.860 --> 00:05:21.400 an equilibrium condition in which if we assume away the transportation costs and that kind 29 00:05:21.400 --> 00:05:49.360 Now, in my interpretation of Professor Salerno, and in fact, this probably most of the audience 30 00:05:49.360 --> 00:05:56.980 would agree on this, including Mises, is that, okay, because this is based on the potential 31 00:05:56.980 --> 00:06:00.980 of arbitrage, that if the exchange rate would be different, we would just purchase the apple 32 00:06:00.980 --> 00:06:05.040 from another city or from another place. 33 00:06:05.040 --> 00:06:11.640 But the Austrian point in respect to this theory is that, okay, but these two apples are two 34 00:06:11.640 --> 00:06:15.340 different goods because they have different spatial locations. 35 00:06:15.340 --> 00:06:32.100 So, in fact, for someone in London, even at the exchange rate like $6 per 1 pound, he 36 00:06:32.100 --> 00:06:39.900 might still buy an apple in London for 2 pounds, even though he would be able to buy 2 apples 37 00:06:39.900 --> 00:06:44.900 in New York at this exchange rate. 38 00:06:44.900 --> 00:06:49.620 Because he just prefers to have an apple in London and not to buy two apples in New York. 39 00:06:49.620 --> 00:06:54.980 He doesn't care about apples in New York. 40 00:06:54.980 --> 00:07:02.980 Now we are coming to the Salernian point or we are approaching it. 41 00:07:02.980 --> 00:07:14.420 And he comes up with alternative specification of the equilibrium conditions for the exchange 42 00:07:14.420 --> 00:07:21.700 exchange rate, which is that we don't care about physically same good in different locations. 43 00:07:21.700 --> 00:07:26.980 We shouldn't care about this in terms of, in case of specific, when we specify the equilibrium 44 00:07:26.980 --> 00:07:34.340 conditions. What we really should care about are the same economic goods and their prices. 45 00:07:34.340 --> 00:07:47.660 They should be important for the determination of the equilibrium exchange rate. 46 00:07:47.660 --> 00:07:53.260 So what he says in fact, he says that it is not important what is the price in dollars 47 00:07:53.260 --> 00:07:57.780 of Apple in New York and the price of Apple in London, but he says that the important 48 00:07:57.780 --> 00:08:02.600 is what is the price of Apple in London in terms of dollars and the price of Apple in 49 00:08:02.600 --> 00:08:17.960 in London in pounds. So, if the dollar price of apple in London is, let's say, six dollars, 50 00:08:17.960 --> 00:08:28.320 and the pound price of apple in London is two pounds, then, of course, if the exchange 51 00:08:28.320 --> 00:08:34.280 Exchange rate, let's assume that if it was $6 per 1 pound, that wouldn't be equilibrium, 52 00:08:34.280 --> 00:08:38.640 because you don't care for which currency you buy the good, you care about the end you 53 00:08:38.640 --> 00:08:43.960 want to attain, not about the means in this case, because you care about the apple in 54 00:08:43.960 --> 00:08:44.960 London. 55 00:08:44.960 --> 00:08:52.040 So, of course, if there is, for example, exchange rate $6 per 1 pound, you assume that people 56 00:08:52.040 --> 00:09:00.440 So we'll just start exchanging pounds for dollars and buying apples for dollars, and not buying 57 00:09:00.440 --> 00:09:02.800 and seizing, buying apples for pounds. 58 00:09:02.800 --> 00:09:08.640 So the pound price of apples will go down, the dollar price of apples will go up and 59 00:09:08.640 --> 00:09:11.520 the exchange rate will go down. 60 00:09:11.520 --> 00:09:17.780 Now this is, in my view, this is perfectly true, like I have nothing, nothing critical 61 00:09:17.780 --> 00:09:19.240 to say about this. 62 00:09:19.240 --> 00:09:29.240 The problem is that this is the case when the currencies fluctuate in a parallel way at a certain geographical space. 63 00:09:29.240 --> 00:09:37.240 So we are assuming that the currency, that all the prices are expressed in London in both pounds and dollars. 64 00:09:37.240 --> 00:09:49.200 But, Professor Salerno, following in some way Mises, is trying to say that in fact there 65 00:09:49.200 --> 00:09:54.840 is no difference between the determination of the exchange rate in this parallel case 66 00:09:54.840 --> 00:10:00.880 and in the case when we have just two geographically separate areas with two separate currencies 67 00:10:00.880 --> 00:10:08.000 the trade together and that have some exchange rate between these currencies that there is no 68 00:10:08.000 --> 00:10:16.800 i will call this separate standard for just sake of being short so that there is in fact no difference 69 00:10:16.800 --> 00:10:21.120 between exchange rate determination in the parallel standard and in the separate standard 70 00:10:21.840 --> 00:10:30.240 and that in fact he claims that the same type of type of parity i was explaining here the type 71 00:10:30.240 --> 00:10:38.240 The same type of parity that determines the exchange rate in the case where the price is expressed in both currencies in one geographical area. 72 00:10:38.240 --> 00:10:45.240 The same type of parity works also in the case where you have separate currency areas. 73 00:10:45.240 --> 00:10:53.240 Now, let me quote him, how this work, how this is supposed to work. 74 00:11:03.240 --> 00:11:05.240 I still have like 10 minutes, right? 75 00:11:05.240 --> 00:11:30.240 Okay, so first he explains how the problem, or first let me just bring some evidence that he understands the determination of the exchange rate to be the same for the parallel and the separate cases. 76 00:11:30.240 --> 00:11:54.840 According to Prof. Salerno, the problem ultimately stems from Mises's analytical coup in perceiving the artificiality of the distinction long maintained in the classical monetary analysis between the case of a parallel standard, i.e. two different monies circulating side by side in domestic use, and the case in which there is only one kind of money employed in domestic transactions, while another kind is in use abroad. 77 00:11:54.840 --> 00:12:22.840 Prevailing opinion distinguishes two cases, that in which two or more domestic kinds of money exist side by side in the parallel standard, and that in which the money in exclusive use at home is of a kind different from money used abroad. 78 00:12:22.840 --> 00:12:33.840 Both cases are dealt with separately, although there is no theoretical difference between them as far as the determination of the exchange ratio between the two sorts of money is concerned. 79 00:12:52.840 --> 00:12:55.160 that Professor Salerno is proposing. 80 00:12:55.160 --> 00:12:56.000 So, 81 00:13:03.400 --> 00:13:05.840 what is then the equilibrium condition? 82 00:13:05.840 --> 00:13:07.720 We have discussed the equilibrium condition 83 00:13:07.720 --> 00:13:09.120 for the parallel case. 84 00:13:09.120 --> 00:13:11.820 Now let's take a look at the equilibrium condition, 85 00:13:11.820 --> 00:13:14.380 how possibly it could work or how could it look like 86 00:13:14.380 --> 00:13:17.180 in the case that you have two separate standards. 87 00:13:17.180 --> 00:13:19.980 And what Professor Salerno is saying is the following. 88 00:13:22.840 --> 00:13:36.840 As in the case of domestically coexisting parallel currencies, each and every specially differentiated good finds expression in the purchasing power array of each of the two national currencies. 89 00:13:36.840 --> 00:13:49.840 Thus, for example, if the final or PPP exchange rate between the US dollar and the British pound is 2 to 1, then the pound price of a house located in London must be exactly one half the dollar price of this same house. 90 00:13:49.840 --> 00:13:59.440 Now, it is true that if the two countries with separate standards trade with each other, 91 00:13:59.440 --> 00:14:07.000 you could in fact buy goods, any goods in foreign country for the domestic currency, 92 00:14:07.000 --> 00:14:09.780 but with the use of the exchange rate. 93 00:14:09.780 --> 00:14:14.240 This is a different case when you compare it with the case of a parallel standard, where 94 00:14:14.240 --> 00:14:18.480 you could directly purchase any good with any of the two currencies, let's say that 95 00:14:18.480 --> 00:14:23.160 we assume only two currencies. So this is, and this in my opinion is the fundamental 96 00:14:23.160 --> 00:14:28.900 difference which in the end will lead us to the conclusion that these two cases are in 97 00:14:28.900 --> 00:14:33.920 fact different and then there is no such a parity in the case of the separate standard 98 00:14:33.920 --> 00:14:46.800 as it is in the parallel standard. Now let me use again an example. Why in the case of 99 00:14:46.800 --> 00:14:53.760 of Separate Standard, the parity that Professor Salerno is talking about is not in fact any 100 00:14:53.760 --> 00:15:00.480 equilibrium condition at all because it holds all the time. Let's say that the exchange 101 00:15:00.480 --> 00:15:14.780 Let's say that the exchange rate is $3 per 1 pound, right? 102 00:15:14.780 --> 00:15:22.160 Now let's say that the price of an apple, and that we are in London, and all apples 103 00:15:22.160 --> 00:15:25.000 in London are sold only for pounds. 104 00:15:25.000 --> 00:15:38.440 Now let's say that the price of Apple in London is £2. 105 00:15:38.440 --> 00:15:46.480 Now if the two countries have trade relationships with each other, it is clear that you could 106 00:15:46.480 --> 00:15:52.280 obtain pounds for dollars and that you could purchase pounds for dollars at the current 107 00:15:52.280 --> 00:15:57.240 exchange rate and you could in fact by the use of dollars you could purchase the apple. 108 00:15:57.240 --> 00:16:00.920 So what is the cost of the apple in terms of dollars? 109 00:16:00.920 --> 00:16:13.920 Well, under the given exchange rate it is 2 pounds times 3 which is 6 dollars, right? 110 00:16:13.920 --> 00:16:23.440 Now what is the parity that is supposed to hold in the equilibrium? 111 00:16:23.440 --> 00:16:31.200 What is the equilibrium condition of the exchange rate? 112 00:16:31.200 --> 00:16:38.700 Well, it is supposed to be the price ratio, the price ratio of the goods sold in terms 113 00:16:38.700 --> 00:16:48.700 In this case, the price of the goods sold in pounds is equal to the price of the goods sold in dollars. 114 00:16:48.700 --> 00:16:51.700 And this is supposed to be equal to the exchange rate. 115 00:16:51.700 --> 00:16:57.700 In that case, in the case of the parallel standard, we have equilibrium. 116 00:16:57.700 --> 00:17:02.700 But here, the problem is that such an equilibrium holds all the time. 117 00:17:02.700 --> 00:17:05.700 Let us take a look at that. 118 00:17:05.700 --> 00:17:29.700 So, in this case, the price ratio of the apple sold for dollars as compared to the price sold for pounds is $6 per 2 pounds, which is $3 per 1 pound. 119 00:17:29.700 --> 00:17:33.700 And this miraculously is equal to the exchange rate. 120 00:17:33.700 --> 00:17:38.700 But the problem is that whatever is the exchange rate, this will hold all the time. 121 00:17:38.700 --> 00:17:42.700 The price ratio will always be equal to the exchange rate. 122 00:17:42.700 --> 00:17:45.700 And let me show why this is so. 123 00:17:45.700 --> 00:17:56.700 Here we know that the price ratio is foreign price of the good divided by domestic price of the good. 124 00:18:00.700 --> 00:18:13.700 And this, in case of separate standards, is equal to domestic price times the exchange rate divided by domestic price. 125 00:18:15.700 --> 00:18:25.700 Well, and it doesn't need much of a rocket science that this will go away and we are getting the exchange rate. 126 00:18:25.700 --> 00:18:42.700 Well, okay. So, whatever the exchange rate is, the price ratio of the goods that is supposed to be the equilibrium condition of the exchange rate 127 00:18:42.700 --> 00:18:51.940 is always equal to the to the actual exchange rate because just as I have just demonstrated so either 128 00:18:51.940 --> 00:18:57.780 we will accept that in case of separate standards we always have equilibrium basing on this theory 129 00:18:57.780 --> 00:19:06.020 or that this kind of concept of equilibrium is kind of meaningless in this respect because the 130 00:19:06.020 --> 00:19:17.340 And here I am getting to the conclusion. 131 00:19:17.340 --> 00:19:26.980 The case of exchange rate determination in case of two parallel standards has an equilibrium 132 00:19:26.980 --> 00:19:32.420 condition where there is an equilibrium where exchange rate has to be equal to the price 133 00:19:32.420 --> 00:19:44.060 price ratio of the goods in terms of the price ratio is result of the division of the price 134 00:19:44.060 --> 00:19:49.740 of the goods of the same economic good in terms of one currency divided by the price 135 00:19:49.740 --> 00:19:52.980 of the same economic good in terms of another currency. 136 00:19:52.980 --> 00:20:00.460 This doesn't have to be always so because these two concepts or these two, the exchange 137 00:20:00.460 --> 00:20:30.460 The exchange rate and the price ratio are a result of independent actions, but in case of separate standard, the supposed condition resulting from the price ratio is direct result of the existing exchange rate, and in fact, as I have showed, is always equal to the exchange rate, therefore, supposedly the equilibrium holds always, but then, if the equilibrium holds always, it is not very meaningful for us 138 00:20:30.460 --> 00:20:55.460 This is the end of my presentation and I would like to thank you for your patience.