Purchasing power parity
The young Keynes also participated in this debate on the exchange rate. In Indian Currency and Finance (1913), he brought to the light the fact that British management of the exchange rate of the Indian rupee was a kind of de facto GES, and argued for the creation of a central bank for India.
In the Tract on Monetary Reform (1923), he introduced the principle known later as the theory of interest rate parity, which explains that there is a trend of adjustment in the spot exchange rate between two currencies according to the interest rates in each country and to the forward exchange rates. For example, noting Rff and R£, the respective interest rates in France and England, and e and ef, the spot and forward exchange rates, one franc invested in France has the same return, 1 FF. (1 + Rff), as one franc exchanged against 1ff sterling, then invested in England with a return of 1~∣f. (1 + R£) sterling, then exchanged against 1ff. (1 + R£). ef francs. The equilibrium without arbitrage opportunity is:
Another improvement in the understanding of the gold standard emerged from Cassel’s 1916 article and the subsequent discussion by Frank William Taussig (1917), Jacob H. Hollander (1918) and Wicksell (1918). It took place during the First World War, which had obliged most of the belligerents to suspend the convertibility of their money into gold. The issue was the determination of the new parities between currencies, therefore the legal prices of gold in francs, pounds, dollars, and so on after the war. Cassel’s answer was that the new exchange rates must allow the parity of purchasing power of monies on goods in different countries, and thus the same purchasing power of gold in these countries.
Cassel’s purchasing power parity theory improved the balance of trade approach. By contrast, Taussig placed the emphasis on the impact of international capital flows between two countries, and the distinction between traded and non-traded goods. He explained that the adjustment process depends on whether countries are on the gold standard or not. He showed that an export of capital from one country that is on the gold standard to another where the gold standard is suspended modifies the exchange rate between the two countries, the gold premium in the second country and the relative prices of goods in both countries. This contradicts Cassel’s purchasing power parity theory. Taussig used the gold point mechanism, being convinced that it was a well- known and accepted adjustment process in the case of two countries on the gold standard. Hollander and Wicksell criticized him for thinking that gold could exit a country without being in excess, and insisted that Ricardo would never have accepted this idea. As Jacob Viner showed in Canada’s Balance of International Indebtedness (1924), Taussig was reviving Thornton’s balance of payments approach. John H. Williams, another of Taussig’s students, wrote his 1920 thesis on the effect of European private capital flows on the exchange rate regime, price of gold, quantity and purchasing power of money in Argentina between 1880 and 1900. This study strongly influenced the young Raul Prebisch (1901-1986), the future first director (1950) of the Economic Commission for Latin America and theorist of the centre-periphery asymmetry.After the First World War, when the return of European countries to the gold standard became the major question, the purchasing power parity theory was central. In European countries, there was a consensus that this theory allowed the determination of either the degree of deflation necessary to restore the pre-war gold parity, or the degree of devaluation necessary to avoid deflation. The controversies arose concerning the choice between deflation and devaluation, the short- and long-term effects of devaluation and the consequences of German transfers for the payment of war reparations.
More consensual was the acceptance of the conclusions of the Genoa Conference in 1922, the leading figure of which was Ralph Hawtrey. The conference proposed the return to an international gold standard system, with the leading European countries adopting a gold bullion standard and the other countries a gold exchange standard. The aim was not only to provide weak countries with a mechanism to manage their exchange rates without holding a gold reserve, but also to avoid an international scarcity of gold that could provoke international deflation. The United States, which did not join the League of Nations, implemented the gold exchange standard in several Latin American countries with Kemmerer’s missions. Great Britain adopted a gold bullion standard in 1925 at pre-war parity, but abandoned it in 1931; France adopted a gold bullion standard in 1928 with an 80 per cent devaluation of the franc, but devalued again in 1936, with the other countries of the 1933 Gold Bloc (Belgium, Luxembourg, the Netherlands, Italy, Poland and Switzerland); the United States adopted a gold bullion standard with a 40 per cent devaluation of the dollar in 1933-34. The restoration of a gold standard in the interwar period failed. Nevertheless, Harry Dexter White, a third student of Taussig, became the senior American official at the 1944 Bretton Woods conference, which established the post-Second World War gold exchange standard.