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According to popular thinking a widening in the
balance of payments deficit raises the demand and lowers the supply of foreign
currency and this leads to depreciation of domestic currency. This theory
suggests that if local prices are going up, for whatever reasons, this gives
rise to more imports and fewer exports i.e. the widening in the balance of
payments deficit. In other words if rises in domestic prices exceed rises of
prices abroad, other things being equal, this will cause balance of payments
deficit and domestic currency depreciation.
The Austrian School, led by the late economist
Ludwig von Mises, however, holds that this cannot be so. As long as the money
supply is not expanding peoples monetary income will not increase.
Consequently they would be forced to restrict their consumption either of
imported or domestic products in response to price rises. In the first case
imports will drop and in the second case exports will increase. Thus the
balance of payments will be brought to a "favourable" state.
The Austrian view holds that the exchange rate of a
currency like the price of any other good is determined by its relative
scarcity in relation to the demand to hold currency. Just like any other
good, both supply and demand determine the price, or the exchange rate of a
currency. According to Mises the rate between two currencies will tend to
equal the ratio of their purchasing power. In other words it is the relative
purchasing power that determines the currencies rate of exchange.
For the mainstream economics the purchasing power of
money is the inverse of a price level depicted by a price index. Mises
however, showed that the price level and general purchasing power of money
cannot be quantified. He showed that the purchasing power of money is an
array of specific goods. As an example the purchasing power of one dollar is
one kg of potatoes i.e. one dollar buys one kg of potatoes, or half a kg of
tomatoes.
In short the price or purchasing power of one dollar
is an array comprising of one kg of potatoes and half kg of tomatoes.
However, tomatoes and potatoes are not commensurable. This means that we can
only quantify the purchasing power of a dollar with respect to specific goods
and not for total goods. Now, since price level is the inverse of the
purchasing power of money it follows then that it cannot be also established.
According to Mises various price indices that are
employed have nothing to do with price levels and their use leads to
erroneous analyses. Furthermore, mainstream economists fall into the trap of
comparing prices of supposedly identical goods in various locations as a
proof that the purchasing power of money in the real world differs in
different markets at the same time.
However, the value of goods is not only determined
by their physical appearance but also by their location. Thus a hamburger
sold in New York is a different product from a hamburger sold in some remote
village in the Sahara desert. For the first is a hamburger in New York while
the second is a hamburger in the Sahara desert village. According to Mises as
long as the exchange relations exist between two different currency areas, economically
the money of one area necessarily functions as the money of the other area,
since both moneys must be utilised in effecting an exchange between the two
areas.
Consequently the purchasing power of currencies is established
with regard to a good in the same location. Thus the purchasing power of the
German mark and the purchasing power of the US dollar are all established
with regard to the same good in the same location. If one loaf of bread in
New York is sold for two marks or one dollar then the rate of exchange
between the mark and the dollar will be 2:1 (two-to-one). If the rate of
exchange will differ from 2:1 this will set an arbitrage activity until the
rate of exchange will adjust towards the ratio of prices.
Thus if the exchange rate is 3:1 this means that the
dollar is over-valued and the mark is under-valued. This will prompt selling
of bread for dollars, to exchange dollars for marks and exchange marks for
bread, thereby securing more bread. According to the Austrian framework then
changes in the exchange rates should closely mirror changes in the purchasing
power of respective currencies. Changes in the purchasing power in turn as we
have seen are determined by the relative scarcity of currencies in relation
to their demand.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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