A Note on the Austrian Theory of Foreign Exchange Rates

0:00Since my topic is only foreign exchange rates, maybe in the beginning I should clarify what we mean by foreign exchange rate. And the thing is that foreign exchange rate is the price of one currency in terms of another currency. Now, another question is what did Austrians say or what have they said about the foreign exchange rate theory? 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.

0:57As you see, it's a long time ago, like, since something, at least apparently something genuine was written on the Austrian, or on the foreign exchange rate theory within the Austrian camp. And of course I'm not saying that there hasn't been written anything at all after this, but that mostly these were just re-statements of the argument mostly presented in Mises's 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 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.

2:15Now, 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. But I don't want to go much into detail into this, I want to get to the theory itself. Professor Salerno is trying to present the Misesian theory as he sees it in a way that encounters it with Castle's Absolute Purchasing Power Parity theory.

3:06But if you read Mises' theory of money and credit, there is like just after the exposition of the theory of this equilibrium theory of foreign exchange rates, he just has a quote where he says that, well, and this is exactly what Gustav Kassel is saying and calls it absolute purchasing power parity. But let me get to the very theory itself, which is, yeah, it is type of absolute purchasing Purchasing Power Parity Theory. Now, what does it mean or what it says? Let me clarify this on the example and try to contrast what Professor Sal So, let's say that we have two places, New York, London.

4:23Let's say that we have two currencies, dollars, pounds. And let's say, let's consider one good, one physically same good that is in both of the places, which is Apple. Now, let's first discuss the Cassellian case. Let's say that the price of Apple in New York is $6. And let's say that the price of apple in London is £2. Now the Castellian theory based on the absolute purchasing power parity says that there is an equilibrium condition in which if we assume away the transportation costs and that kind Now, in my interpretation of Professor Salerno, and in fact, this probably most of the audience would agree on this, including Mises, is that, okay, because this is based on the potential of arbitrage, that if the exchange rate would be different, we would just purchase the apple from another city or from another place.

6:05But the Austrian point in respect to this theory is that, okay, but these two apples are two different goods because they have different spatial locations. So, in fact, for someone in London, even at the exchange rate like $6 per 1 pound, he might still buy an apple in London for 2 pounds, even though he would be able to buy 2 apples in New York at this exchange rate. Because he just prefers to have an apple in London and not to buy two apples in New York. He doesn't care about apples in New York.

6:54Now we are coming to the Salernian point or we are approaching it. And he comes up with alternative specification of the equilibrium conditions for the exchange exchange rate, which is that we don't care about physically same good in different locations. We shouldn't care about this in terms of, in case of specific, when we specify the equilibrium conditions. What we really should care about are the same economic goods and their prices. They should be important for the determination of the equilibrium exchange rate.

7:47So what he says in fact, he says that it is not important what is the price in dollars of Apple in New York and the price of Apple in London, but he says that the important is what is the price of Apple in London in terms of dollars and the price of Apple in in London in pounds. So, if the dollar price of apple in London is, let's say, six dollars, and the pound price of apple in London is two pounds, then, of course, if the exchange Exchange rate, let's assume that if it was $6 per 1 pound, that wouldn't be equilibrium, because you don't care for which currency you buy the good, you care about the end you want to attain, not about the means in this case, because you care about the apple in London.

8:44So, of course, if there is, for example, exchange rate $6 per 1 pound, you assume that people So we'll just start exchanging pounds for dollars and buying apples for dollars, and not buying and seizing, buying apples for pounds. So the pound price of apples will go down, the dollar price of apples will go up and the exchange rate will go down. Now this is, in my view, this is perfectly true, like I have nothing, nothing critical to say about this. The problem is that this is the case when the currencies fluctuate in a parallel way at a certain geographical space. So we are assuming that the currency, that all the prices are expressed in London in both pounds and dollars.

9:37But, Professor Salerno, following in some way Mises, is trying to say that in fact there is no difference between the determination of the exchange rate in this parallel case and in the case when we have just two geographically separate areas with two separate currencies the trade together and that have some exchange rate between these currencies that there is no i will call this separate standard for just sake of being short so that there is in fact no difference between exchange rate determination in the parallel standard and in the separate standard and that in fact he claims that the same type of type of parity i was explaining here the type 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.

10:38The same type of parity works also in the case where you have separate currency areas. Now, let me quote him, how this work, how this is supposed to work.

11:03I still have like 10 minutes, right? 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. 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.

11:54Prevailing 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. 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.

12:52that Professor Salerno is proposing. So,

13:03what is then the equilibrium condition? We have discussed the equilibrium condition for the parallel case. Now let's take a look at the equilibrium condition, how possibly it could work or how could it look like in the case that you have two separate standards. And what Professor Salerno is saying is the following. 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. 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.

13:49Now, it is true that if the two countries with separate standards trade with each other, you could in fact buy goods, any goods in foreign country for the domestic currency, but with the use of the exchange rate. This is a different case when you compare it with the case of a parallel standard, where you could directly purchase any good with any of the two currencies, let's say that we assume only two currencies. So this is, and this in my opinion is the fundamental difference which in the end will lead us to the conclusion that these two cases are in fact different and then there is no such a parity in the case of the separate standard as it is in the parallel standard. Now let me use again an example. Why in the case of of Separate Standard, the parity that Professor Salerno is talking about is not in fact any equilibrium condition at all because it holds all the time. Let's say that the exchange

15:00Let's say that the exchange rate is $3 per 1 pound, right? Now let's say that the price of an apple, and that we are in London, and all apples in London are sold only for pounds. Now let's say that the price of Apple in London is £2. Now if the two countries have trade relationships with each other, it is clear that you could obtain pounds for dollars and that you could purchase pounds for dollars at the current exchange rate and you could in fact by the use of dollars you could purchase the apple.

15:57So what is the cost of the apple in terms of dollars? Well, under the given exchange rate it is 2 pounds times 3 which is 6 dollars, right? Now what is the parity that is supposed to hold in the equilibrium? What is the equilibrium condition of the exchange rate? Well, it is supposed to be the price ratio, the price ratio of the goods sold in terms In this case, the price of the goods sold in pounds is equal to the price of the goods sold in dollars.

16:48And this is supposed to be equal to the exchange rate. In that case, in the case of the parallel standard, we have equilibrium. But here, the problem is that such an equilibrium holds all the time. Let us take a look at that. 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. And this miraculously is equal to the exchange rate.

17:33But the problem is that whatever is the exchange rate, this will hold all the time. The price ratio will always be equal to the exchange rate. And let me show why this is so. Here we know that the price ratio is foreign price of the good divided by domestic price of the good.

18:00And this, in case of separate standards, is equal to domestic price times the exchange rate divided by domestic price. Well, and it doesn't need much of a rocket science that this will go away and we are getting the exchange rate. 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 is always equal to the to the actual exchange rate because just as I have just demonstrated so either we will accept that in case of separate standards we always have equilibrium basing on this theory or that this kind of concept of equilibrium is kind of meaningless in this respect because the And here I am getting to the conclusion.

19:17The case of exchange rate determination in case of two parallel standards has an equilibrium condition where there is an equilibrium where exchange rate has to be equal to the price price ratio of the goods in terms of the price ratio is result of the division of the price of the goods of the same economic good in terms of one currency divided by the price of the same economic good in terms of another currency. This doesn't have to be always so because these two concepts or these two, the exchange 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 This is the end of my presentation and I would like to thank you for your patience.