WEBVTT

NOTE 11.12. Exchange Rates of Coexisting Moneys

1
00:00:00.000 --> 00:00:06.000
12. Exchange Rates of Coexisting Monies

2
00:00:06.000 --> 00:00:13.000
Up to this point we have analyzed the market in terms of a single money and its purchasing power.

3
00:00:13.000 --> 00:00:20.000
This analysis is valid for each and every type of medium of exchange existing on the market.

4
00:00:20.000 --> 00:00:30.000
But if there is more than one medium coexisting on the market, what determines the exchange ratios between the various media?

5
00:00:30.000 --> 00:00:40.000
Although on an unhampered market there is a gradual tendency for one single money to be established, this tendency works very slowly.

6
00:00:40.000 --> 00:00:49.000
If two or more commodities offer good facilities and are both especially marketable, they may coexist as monies.

7
00:00:49.000 --> 00:01:02.240
For centuries, gold and silver were two commodities that co-existed as monies. Both had similar

8
00:01:02.240 --> 00:01:11.800
advantages in scarcity, desirability for non-monetary purposes, portability, durability, etc. Gold,

9
00:01:11.800 --> 00:01:18.600
however, being relatively far more valuable per unit of weight, was found to be more useful

10
00:01:18.600 --> 00:01:31.840
It is impossible to predict whether the market would have continued indefinitely to use gold

11
00:01:31.840 --> 00:01:39.680
and silver, or whether one would have gradually ousted the other as a general medium of exchange.

12
00:01:39.680 --> 00:01:45.600
For in the late 19th century, most western countries conducted a coup d'etat against

13
00:01:45.600 --> 00:02:04.600
Gold and silver could and did coexist side by side in the same countries or throughout the world market, or one could function as money in one country and one in another.

14
00:02:04.600 --> 00:02:09.600
Our analysis of the exchange rate is the same in both cases.

15
00:02:09.600 --> 00:02:14.600
What determines the exchange rate between two or more monies?

16
00:02:14.600 --> 00:02:27.100
Two different kinds of money will exchange in a ratio corresponding to the ratio of the purchasing power of each in terms of all the other economic goods.

17
00:02:27.100 --> 00:02:36.600
Thus, suppose that there are two coexisting monies, gold and silver, and the purchasing power of gold is double that of silver.

18
00:02:36.600 --> 00:02:43.280
1. That is, that the money price of every commodity is double in terms of silver what

19
00:02:43.280 --> 00:02:51.200
it is in terms of gold. 1 ounce of gold exchanges for 50 pounds of butter, and 1 ounce of silver

20
00:02:51.200 --> 00:02:59.120
exchanges for 25 pounds of butter. 1 ounce of gold will then tend to exchange for 2 ounces

21
00:02:59.120 --> 00:03:06.760
The exchange ratio of gold and silver will tend to be 1 to 2.

22
00:03:06.760 --> 00:03:13.840
If the rate at any time deviates from 1 to 2, market forces will tend to re-establish

23
00:03:13.840 --> 00:03:19.640
the parity between the purchasing powers and the exchange rate between them.

24
00:03:19.640 --> 00:03:26.800
This equilibrium exchange rate between two monies is termed the purchasing power parity.

25
00:03:26.800 --> 00:03:33.880
Thus, suppose that the exchange rate between gold and silver is one to three, three ounces

26
00:03:33.880 --> 00:03:37.680
of silver exchanging for one ounce of gold.

27
00:03:37.680 --> 00:03:44.440
At the same time, the purchasing power of an ounce of gold is twice that of silver.

28
00:03:44.440 --> 00:03:51.040
It will now pay people to sell commodities for gold, exchange the gold for silver, and

29
00:03:51.040 --> 00:03:58.400
and then exchange the silver back into commodities, thereby making a clear arbitrage gain.

30
00:03:58.400 --> 00:04:05.220
For example, people will sell 50 pounds of butter for 1 ounce of gold, exchange the gold

31
00:04:05.220 --> 00:04:11.860
for 3 ounces of silver, and then exchange the silver for 75 pounds of butter, gaining

32
00:04:11.860 --> 00:04:14.740
25 pounds of butter.

33
00:04:14.740 --> 00:04:21.940
Similar gains from this arbitrage action will take place for all other commodities.

34
00:04:21.940 --> 00:04:28.980
Arbitrage will restore the exchange rate between silver and gold to its purchasing power parity.

35
00:04:28.980 --> 00:04:34.780
The fact that holders of gold increase their demand for silver in order to profit by the

36
00:04:34.780 --> 00:04:43.000
arbitrage action will make silver more expensive in terms of gold and, conversely, gold cheaper

37
00:04:43.000 --> 00:04:50.680
In terms of silver, the exchange rate is driven in the direction of 1 to 2. Furthermore, holders

38
00:04:50.680 --> 00:04:57.800
of commodities are increasingly demanding gold to take advantage of the arbitrage, and this raises

39
00:04:57.800 --> 00:05:04.920
the purchasing power of gold. In addition, holders of silver are buying more commodities to make the

40
00:05:04.920 --> 00:05:11.880
arbitrage profit, and this action lowers the purchasing power of silver. Hence, the ratio

41
00:05:11.880 --> 00:05:18.880
The flow of the purchasing powers moves from 1 to 2 in the direction of 1 to 3.

42
00:05:18.880 --> 00:05:27.880
The process stops when the exchange rate is again at purchasing power parity, when arbitrage gains cease.

43
00:05:27.880 --> 00:05:33.880
Arbitrage gains tend to eliminate themselves and to bring about equilibrium.

44
00:05:33.880 --> 00:05:43.380
It should be noted that in the long run the movement in the purchasing powers will probably not be important in the equilibrating process.

45
00:05:43.380 --> 00:05:54.380
With the arbitrage gains over, demands will probably revert back to what they were formerly, and the original ratio of purchasing powers will be restored.

46
00:05:54.380 --> 00:06:01.380
In the case under discussion, the equilibrium rate will likely remain at 1 to 2.

47
00:06:01.380 --> 00:06:09.380
Thus, the exchange rate between any two monies will tend to be at the purchasing power parity.

48
00:06:09.380 --> 00:06:15.540
Any deviation from the parity will tend to eliminate itself and re-establish the parity

49
00:06:15.540 --> 00:06:16.780
rate.

50
00:06:16.780 --> 00:06:23.220
This holds true for any monies, including those used mainly in different geographical

51
00:06:23.220 --> 00:06:24.220
areas.

52
00:06:24.220 --> 00:06:30.200
Whether the exchanges of monies occur between citizens of the same or different geographical

53
00:07:00.200 --> 00:07:06.920
It is impossible for economics to state whether, if the money market had remained free, gold

54
00:07:06.920 --> 00:07:12.840
and silver would have continued to circulate side by side as monies.

55
00:07:12.840 --> 00:07:19.120
There has been in monetary history a curious reluctance to allow monies to circulate at

56
00:07:19.120 --> 00:07:22.720
freely fluctuating exchange ratios.

57
00:07:22.720 --> 00:07:28.160
Whether one of the monies or both would be used as units of account would be up to the

58
00:07:28.160 --> 00:07:31.080
The Market to Decide at its Convenience