11.12. Exchange Rates of Coexisting Moneys

0:0012. Exchange Rates of Coexisting Monies Up to this point we have analyzed the market in terms of a single money and its purchasing power. This analysis is valid for each and every type of medium of exchange existing on the market. But if there is more than one medium coexisting on the market, what determines the exchange ratios between the various media? Although on an unhampered market there is a gradual tendency for one single money to be established, this tendency works very slowly. If two or more commodities offer good facilities and are both especially marketable, they may coexist as monies.

0:49For centuries, gold and silver were two commodities that co-existed as monies. Both had similar advantages in scarcity, desirability for non-monetary purposes, portability, durability, etc. Gold, however, being relatively far more valuable per unit of weight, was found to be more useful It is impossible to predict whether the market would have continued indefinitely to use gold and silver, or whether one would have gradually ousted the other as a general medium of exchange.

1:39For in the late 19th century, most western countries conducted a coup d'etat against 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. Our analysis of the exchange rate is the same in both cases. What determines the exchange rate between two or more monies? 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.

2:27Thus, suppose that there are two coexisting monies, gold and silver, and the purchasing power of gold is double that of silver. 1. That is, that the money price of every commodity is double in terms of silver what it is in terms of gold. 1 ounce of gold exchanges for 50 pounds of butter, and 1 ounce of silver exchanges for 25 pounds of butter. 1 ounce of gold will then tend to exchange for 2 ounces The exchange ratio of gold and silver will tend to be 1 to 2. If the rate at any time deviates from 1 to 2, market forces will tend to re-establish the parity between the purchasing powers and the exchange rate between them.

3:19This equilibrium exchange rate between two monies is termed the purchasing power parity. Thus, suppose that the exchange rate between gold and silver is one to three, three ounces of silver exchanging for one ounce of gold. At the same time, the purchasing power of an ounce of gold is twice that of silver. It will now pay people to sell commodities for gold, exchange the gold for silver, and and then exchange the silver back into commodities, thereby making a clear arbitrage gain. For example, people will sell 50 pounds of butter for 1 ounce of gold, exchange the gold for 3 ounces of silver, and then exchange the silver for 75 pounds of butter, gaining 25 pounds of butter.

4:14Similar gains from this arbitrage action will take place for all other commodities. Arbitrage will restore the exchange rate between silver and gold to its purchasing power parity. The fact that holders of gold increase their demand for silver in order to profit by the arbitrage action will make silver more expensive in terms of gold and, conversely, gold cheaper In terms of silver, the exchange rate is driven in the direction of 1 to 2. Furthermore, holders of commodities are increasingly demanding gold to take advantage of the arbitrage, and this raises the purchasing power of gold. In addition, holders of silver are buying more commodities to make the arbitrage profit, and this action lowers the purchasing power of silver. Hence, the ratio The flow of the purchasing powers moves from 1 to 2 in the direction of 1 to 3.

5:18The process stops when the exchange rate is again at purchasing power parity, when arbitrage gains cease. Arbitrage gains tend to eliminate themselves and to bring about equilibrium. It should be noted that in the long run the movement in the purchasing powers will probably not be important in the equilibrating process. 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. In the case under discussion, the equilibrium rate will likely remain at 1 to 2. Thus, the exchange rate between any two monies will tend to be at the purchasing power parity.

6:09Any deviation from the parity will tend to eliminate itself and re-establish the parity rate. This holds true for any monies, including those used mainly in different geographical areas. Whether the exchanges of monies occur between citizens of the same or different geographical

7:00It is impossible for economics to state whether, if the money market had remained free, gold and silver would have continued to circulate side by side as monies. There has been in monetary history a curious reluctance to allow monies to circulate at freely fluctuating exchange ratios. Whether one of the monies or both would be used as units of account would be up to the The Market to Decide at its Convenience