When this common measure has ceased to be effective and we have instead a number of independent systems of inconvertible paper, what basic fact determines the rates at which units of the different currencies exchange for one another?
The explanation is to be found in the doctrine, as old in itself as Ricardo, with which Professor Cassel has lately familiarised the public under the name of “Purchasing Power Parity.”[26]
[26] This term was first introduced into economic literature in an article contributed by Prof. Cassel to the Economic Journal, December 1918. For Prof. Cassel’s considered opinions on the whole question, see his Money and Foreign Exchange after 1914 (1922). The theory, as distinct from the name, is essentially Ricardo’s.
This doctrine in its baldest form runs as follows: (1) The purchasing power of an inconvertible currency within its own country, i.e. the currency’s internal purchasing power, depends on the currency policy of the Government and the currency habits of the people, in accordance with the Quantity Theory of Money just discussed. (2) The purchasing power of an inconvertible currency in a foreign country, i.e. the currency’s external purchasing power, must be the rate of exchange between the home-currency and the foreign-currency, multiplied by the foreign-currency’s purchasing power in its own country. (3) In conditions of equilibrium the internal and external purchasing powers of a currency must be the same, allowance being made for transport charges and import and export taxes; for otherwise a movement of trade would occur in order to take advantage of the inequality. (4) It follows, therefore, from (1), (2), and (3) that the rate of exchange between the home-currency and the foreign-currency must tend in equilibrium to be the ratio between the purchasing powers of the home-currency at home and of the foreign-currency in the foreign country. This ratio between the respective home purchasing powers of the two currencies is designated their “purchasing power parity.”
If, therefore, we find that the internal and external purchasing powers of the home-currency are widely different, and, which is the same thing, that the actual exchange rates differ widely from the purchasing power parities, then we are justified in inferring that equilibrium is not established, and that, as time goes on, forces will come into play to bring the actual exchange rates and the purchasing power parities nearer together. The actual exchanges are often more sensitive and more volatile than the purchasing power parities, being subject to speculation, to sudden movements of funds, to seasonal influences, and to anticipations of impending changes in purchasing power parity (due to relative inflation or deflation); though also on other occasions they may lag behind. Nevertheless it is the purchasing power parity, according to this doctrine, which corresponds to the old gold par. This is the point about which the exchanges fluctuate, and at which they must ultimately come to rest; with one material difference, namely, that it is not itself a fixed point,—since, if internal prices move differently in the two countries under comparison, the purchasing power parity also moves, so that equilibrium may be restored, not only by a movement in the market rate of exchange, but also by a movement of the purchasing power parity itself.
At first sight this theory appears to be one of great practical utility; and many persons have endeavoured to draw important practical conclusions about the future course of the exchanges from charts exhibiting the divergences between the market rate of exchange and the purchasing power parities,—undeterred by the perplexity whether an existing divergence from equilibrium will be remedied by a movement of the exchanges or of the purchasing power parity or of both.
In practical applications of the doctrine there are, however, two further difficulties, which we have allowed so far to escape our attention,—both of them arising out of the words allowance being made for transport charges and import and export taxes. The first difficulty is how to make allowance for such charges and taxes. The second difficulty is how to treat purchasing power over goods and services which do not enter into international trade at all.
The doctrine, in the form in which it is generally applied, endeavours to deal with the first difficulty by assuming that the percentage difference between internal and external purchasing power at some standard date, when approximate equilibrium may be presumed to have existed, generally the year 1913, may be taken as an approximately satisfactory correction for the same disturbing factors at the present time. For example, instead of calculating directly the cost of a standard set of goods at home and abroad respectively, the calculations are made that $2 are required to buy in the United States a standard set which $1 would have bought in 1913, and that £2·43 are required to buy in England what £1 would have bought in 1913. On this basis (the pre-war purchasing power parity being assumed to be in equilibrium with the pre-war exchange of $4·86 = £1) the present purchasing power parity between dollars and sterling is given by $4 = £1, since 4·86 × 2 ÷ 2·43 = 4.
The obvious objection to this method of correction is that transport and tariff costs, especially if this term is taken to cover all export and import regulations, including prohibitions and official or semi-official combines for differentiating between export and home prices, are notoriously widely different in many cases from those which existed in 1913. We should not get the same result if we were to take some year other than 1913 as the basis of the calculation.
The second difficulty—the treatment of purchasing power over articles which do not enter into international trade—is still more serious. For, if we restrict ourselves to articles entering into international trade and make exact allowance for transport and tariff costs, we should find that the theory is always in accordance with the facts, with perhaps a short time-lag, the purchasing power parity being never very far from the market rate of exchange. Indeed, it is the whole business of the international merchant to see that this is so; for whenever the rates are temporarily out of parity he is in a position to make a profit by moving goods. The prices of cotton in New York, Liverpool, Havre, Hamburg, Genoa, and Prague, expressed in dollars, sterling, francs, marks, lire, and krone respectively, are never for any length of time much divergent from one another on the basis of the exchange rates actually obtaining in the market, due allowance being made for tariffs and the cost of moving cotton from one centre to another; and the same is true of other articles of international trade, though with an increasing time-lag as we pass to articles which are not standardised or are not handled in organised markets. In fact, the theory, stated thus, is a truism, and as nearly as possible jejune.