Balance of payments approach, exchange rate and gold points
The balance of payments approach was introduced by Henry Thornton in An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802) to explain the flows of precious metal (gold and silver) linked to financial transfers when bank notes are convertible into legal tender coins and the high price of bullion when the convertibility is suspended.
To this end, Thornton developed the gold points mechanism (hereafter GPM), previously envisioned by James Steuart in his An Inquiry into the Principles of Political Oeconomy (1767). According to Thornton’s GPM, gold and silver fulfil the function of international means of payment by seeking “like [other commodities] that country in which it is the dearest” (Thornton 1802 [1991]: 145). This function is achieved through an arbitrage performed by merchants between the legal price of precious metals in England, their legal price in foreign countries, the merchants’ international trading costs and the market exchange rate of the pound sterling.The legal prices of gold and silver define the par of exchange, while the supply and demand for pound sterling and foreign currencies determine the market exchange rates. When the exchange rates fall below (rise above) the par of exchange by an amount that exceeds the international trading costs of precious metals, “ merchants... yield a profit” (ibid.: 145) by exporting (importing) gold and silver. The levels of exchange rates at which the gain of arbitrage between exchange rate and par of exchange equals its trading cost are called gold and silver export and import points. The gold export (import) point is the level of the exchange rate of the pound sterling, below (above) the par of exchange, at which it is profitable to buy (sell) British bank deposits by selling (buying) foreign bank deposits, then to buy gold - either specie or bullion - in London (in the foreign country) by selling the bank deposits - either at the bank at the legal price or in the market - then to export (import) gold to (from) the foreign country, incurring the trading cost, and to sell it by buying foreign (British) bank deposits (either at the bank at the legal price or in the market) in the foreign country (in London).
For example, consider the currency market between London and Paris, in which the par of exchange rate is 25.22 FF/£ and the gold transfer cost is 3.85 per cent.
The gold import point in London (gold export point from Paris) is 26.19 FF/£, and the gold export point from London (gold import point in Paris) is 24.28 FF/£. Let us assume an equilibrium, then an export of £105 capital from England to France, with no other changes (in particular there is no change in the purchasing powers of the napoleon and the guinea). This export of capital provokes an excess supply of £105 and an excess demand for 2648.10 FF on the currency market, so that the exchange rate of sterling falls. When it reaches 24.28 FF/£, arbitrageurs supply 2549.40 FF and demand £105. Thereafter: (1) the £105 are exchanged in a London bank for 100 guineas; (2) the guineas are melted down, leave England, and are then coined in France for 132.4 napoleons whose value is 2648 FF, making a gain of 98.6 FF which covers the trading costs of the gold.In the GPM, international flows of gold and silver are an effect of fluctuations in exchange rates, that is, the prices at which bank deposits are exchanged between countries. Within the levels of the gold and silver export and import points, there is no trading of precious metals, that is, no supply or demand in the currency market of sterling and foreign currencies to finance exports or imports of gold and silver. In this case, in the currency market, the supply and demand of bank deposits concern the trading of goods, except gold and silver, and financial flows. It is only when the forces of supply and demand in the currency market cause the exchange rate to reach the gold and silver import or export point that supply and demand are dominated by the arbitrage transactions, that is, the import and export of gold and silver.