The high price of bullion and the exchange rate

Ricardo wrote The High Price of Bullion, a Proof of the Depreciation of Bank Notes. He added that it is the high price of bullion that causes the fall in the exchange rate. The latter proposition is the foundation of the former.

The price-specie flow mechanism shows that the value of gold money varies according to variations in its quantity and in the quantity of goods that (money helps to) circu­late. The same mechanism also shows that the quantity of gold money varies to adjust its value to the international level. This double mechanism is described with gold coins that are in good shape. However, what happens when coins are debased, which means that the quantity of gold contained in the coin is lower than the mint one, that is, lower than the quantity in the bullion? What happens in an intermediary situation when the coins are not debased but the payment of banknotes is suspended? The same law explains all the possible cases: the surplus of gold money will leave the country as long as the value of the coins resulting from their weight is lower than their value abroad. The coins debased in a proportion of 20 per cent will be exported as long as their domestic value is more than 20 per cent lower than the foreign value of the non-debased coins, which means that the outflow will continue until this difference disappears; as soon as this point of equilibrium is reached the arbitrage with debased coins stops. However, there remains an arbitrage opportunity with bullion whose foreign value is 25 per cent higher than the domestic value of debased coins. The equilibrium with no arbitrage opportunity sup­poses that the market price of bullion rises 25 per cent; that is, the increase in the market price over the mint price is proportional to the debasement of coins.

From the “gold points mechanism” point of view, the circulation of debased coins means a fall in the par of exchange. The arbitrageurs will send the exchange rate down. The same effect comes from a market price of gold above the mint price of gold, supposed to be caused by an excess of inconvertible banknotes. On the currency market, nobody will buy sterling pounds at the legal parity if it is necessary to pay an additional 25 per cent to buy gold in London, in the form of either debased coins at mint price or bullion at market price. As long as the exchange rate of the pound sterling has not fallen 25 per cent, it is profitable to send gold from the continent to London. The equilibrium with no arbitrage opportunities supposes this 25 per cent fall in the exchange rate. However, it is important to note that again, Ricardo did not describe these arbitrages. He did not expound the arbitrage that leads to the increase in the market price of bullion. Nor did he talk about the arbitrage that provokes the fall in the exchange rate. But he was convinced that the high price of bullion, which is the proof of the depreciation of debased coins or unconvertible banknotes, was also at the root of the fall in the exchange rate.

According to Malthus in 1811, and the Banking School authors 30 years later, Ricardo was wrong. They argued that the high price of bullion was not the cause but an effect of the fall in the exchange rate, in the same way that Thornton explained the arbitrages involved. However, these authors were not able to persuade their contemporaries. In fact, in spite of the strength of Thornton’s theory of the arbitrages at work in the cur­rency markets, Ricardo overshadowed him. Thereafter, the Currency School won the battle against the Banking School, and the price-specie flow mechanism dimmed the brightness of the GPM. We would have to wait until the end of the First World War for new light to be shed on the GPM, thanks to the disciples of Frank William Taussig, in particular Jacob Viner (1924) and James Angell (1926).

Jerome de Boyer des Roches and Ricardo Solis Rosales

See also:

Balance of payments and exchange rates (III); Banking and currency schools (II); British classical political economy (II); Ralph George Hawtrey (I); Thomas Robert Malthus (I); Mercantilism and the science of trade (II); Monetarism (II); Money and banking (III); Open economy macroeconomics (III); David Ricardo (I); Adam Smith (I); Henry Thornton (I); Thomas Tooke (I); Value and price (III).