Exchange rates and changes in the money supply

locations. To talk about price differentials of the “same goods” in different locations that are supposed to bring about changes in related prices, including exchange rates if the locations in question are in two different currency areas, is meaningless. It is the same as to talk about price differential between a plum and a Mercedes. These are two different goods and no related actions of individuals could be deduced barely from their price differential.

We are now at the point to sum up the present section. Price differentials between costs of the production process and potential revenue of its outcome could play an important issue in explanation of exchange rates. However, one should be aware of all production factors that are to be involved in the production process. In the case where production represents transportation of “underpriced” good to a place where it is “overpriced”, one should not forget to include into the “costs of production” also purchase or renting of the spatial position as it might represent important production factor that matters.

The very notion of non-neutrality of money is definitely not revolutionary in itself. What, however, makes the Austrian concept – presented here, distinctive, is its causal step-by-step analysis of the process related with changes in the quantity of money and quantity of demanded money⁴². The starting point of the analysis is that as a consequence of some event, some particular person or rather particular group of people in the economic system have different amount of money than they actually would have had⁴³. All resulting effects then spread around the economy from this particular person or group of the people and their chains of actions.

These “resulting effects” that are of our interest in the context of the exchange rate determination are related with the phenomenon of chain of price-changes. This phenomenon could be illustrated in the following way⁴⁴: change in one’s money expenditure compared to the situation that would have been otherwise, i.e., without this change, leads to change in prices of certain goods and to change in revenues of producers of these goods compared to the situation of absence of this change in expenditures. In the following step, money-receivers will react in the similar way and change their expenditures, and so on. The phenomenon of changed expenditures will be thus moving in respective chains throughout the whole economy step-by-step changing corresponding prices. It is clear that such a process in many cases does not have a considerable impact on the overall price system and the structure of relative prices.

Further analyses, will be therefore related with impacts that are to be expected to have considerable and, at least to some extent, clear consequences that is, the impacts of changes in the money supply induced by the central monetary authority. Let us now then discuss the case of increase in the amount of money by the central bank.

What is direct consequence of induced increase in the amount of money in the economy by the central bank? Cash holdings of particular people in the economy increase. These people have suddenly more notes than otherwise. As a consequence, there are now two groups of people in the economy – those whose cash balances have been increased, as a direct effect of the increase in the money supply, and those whose cash balances have not been increased. At

42 The reason why we are talking about „quantity of demanded money“ is simply because this is the variable that affects prices in the economy. If the quantity of money in the economy increases, for example, it is important for other actors and for prices in the economy how much of these new money will be people willing to hold in the respective stages of the movement of this money throughout the economy.

43 It is the fact of real life that these changes do happen at some particular time and place and not in the overall and proportionate way in the whole economy. The later case will not be therefore dealt with – on this see Mises (1971, pp. 206 ff.) and Mises (1996, pp. 416 ff.).

44 Cf. Mises (1971, pp. 131-145, pp. 206 ff.), Mises (1996, pp. 416 ff.), Rothbard (2004, pp. 811-815).

this point, we will presuppose that the additional cash balances, or at least part of them, will be spent⁴⁵. In the opposite case, there would not be much to talk about.

The picture below illustrates the state of affairs with no increase in the amount of money. The apparatus represents chains of actions of three individuals – A, B, C – affecting each other. It should be noted that it is in no way necessary that the actions of individuals are somehow automatically temporally coordinated in a way that let’s say Stage X of person B should take place at the same time as Stage X of person C. These could, in principle, occur in completely different times. The only necessary interpersonal synchronization occurs when two persons act in concert⁴⁶.

Intermediary Stage 2 of A Intermediary

Stage 3 of A

End of A (Stage A1) Present state of

individual A

_{End of B}

(Stage B1) Intermediary

Stage 3 of B

Intermediary Stage 2 of B Present state of

individual B

_{End of C}

(Stage C1) Intermediary

Stage 3 of C Intermediary

Stage 2 of C Present state of

individual C

Figure 22: Part of the economy before increase in the money supply

The figure hence presents the interdependency of three respective chains of actions, where

„Stages“ stand for important milestones, like purchase of a production factor, etc. The ellipses mark this interdependence. Stage 3 of B, that is regarded as the means to attain the End of B, is dependent on some of C’s actions that lead towards Stage 3 of C. On the other hand, B’s actions that follow Stage 3 of B are counted on in the plan of A and are therefore required for attaining of Stage 2 of A. Let’s say that person B above sells apples to both – A and C, and that ellipses suggest situations when the voluntary exchange of money for apples takes place.

To get one step further, we will assume increase in the amount of money in the economy, particularly that the cash balance of C is increased in the Present state of individual C.

Increased amount of money in cash balance makes the marginal utility of money for C lower than otherwise and he is willing to spend higher amount of his balance for apples. The higher amount of apples is bought from B at the higher price and the stock of B in Stage 1 of B is lower when compared to the previous alternative case. On the other hand, his cash balance is

45 Or, which is the same, that the money that would have been kept in cash balances will be spent instead.

46 Cf. Mises (1996, p. 102).

higher. Marginal utility of apples for B is higher, marginal utility of money for B declines.

There is just not enough apples to be sold to A for the price that was relevant in the alternative case. A has to buy lower quantity and pay higher price. The arrow in the picture below portrays the causal relationships of the effect of increased in the money supply across the economy. Respective ends of all three individuals are now subject to change as the means in their hands are changed.

Present state of

individual A Intermediary

Stage 2 of A Intermediary

Stage 3 of A

Present state of

individual B Intermediary

Stage 2 of B Intermediary

Stage 3 of B

End of B (Stage B1)

End of C (Stage C1) Intermediary

Stage 3 of C

Intermediary Stage 2 of C Present state of

individual C

End of A (Stage A1)

Figure 23: Part of the economy after the increase in the money supply

The picture above could be reproduced many times to represent similar processes that take place over the economy in order to illustrate what really happens when the central bank increases the amount of money. On the one hand, these “similar” processes portray the situation of other people who receive the additional money from the central bank. On the other hand, the very same processes will take place in cases of the people who receive the additional money in the later turns, like person B in our example.

The example above illustrated the case of increase in the amount of money, however, the very same rules hold for a decrease in the amount of money. Again, this usually starts at some certain place in the economy and decreased money expenditures spread only in a step-by-step way. As a consequence, price decreases will spread only gradually as well.

The appropriate question now stands: “Of what use is this knowledge of consequences in changes of the money supply for understanding of the phenomenon of exchange rates?” The answer is related with the section that discussed changes in prices of the goods. As we have already seen, increases or decreases in prices have specific effects on the exchange rate in respect with their nature to be a complement or rather substitutes in respect with goods sold for the other currency. From this point of view, it is crucial who will receive the additional money as first, or from whom will be the money withdrawn, and which respective purchases and prices will be affected. With this knowledge, one could understand impact of changes in the money supply on corresponding changes in the exchange rate. Increase in the amount of

dollars could therefore under some circumstances, at least temporarily, induce tendency for appreciation of dollar. Mutatis mutandis, decrease in the amount of dollars could in the same way lead, at least temporarily, towards depreciation of dollar.

The question now stands, what will happen after the results of changes in the amount of money will spread all over the economy. But before we will be able to get to this point, we have to first explain how is it possible that some “spreading across the economy” will take place at all. It should be pointed out that this is not necessary from a strictly academic perspective – the same additional amount of money could be spent for goods of one seller and this seller could again use this additional money for the goods of some single producer and so on. The same could hold for the reduced amount of money – it might be always one person at a time who will suffer from reduction in the money stock. However, this is unlikely to happen as each additional affected person could shift the effects to more than one person, these other people could again act in a similar way and so on. It is therefore very probable that effects will spread all over the economy, in other words, most prices are very likely to be affected – by increase in the case of increase in the amount of money and by decrease in case of decreased amount of money. The question now stands: Does increase in the amount of money necessary lead to a higher exchange rate than otherwise and does decrease in the amount of money necessary lead to a lower exchange rate than otherwise?

From the most general perspective it seems that there is no reason to assume that people holding additional dollars will not be willing to offer higher amount of money for the foreign goods as well as for the domestic goods, in other words, that the prices of the foreign goods as well as those of domestic goods in dollar terms will just increase. Moreover, as the prices of goods sold for dollars increase, holders of pounds will be more reluctant to supply the same amounts of pounds for one dollar and will require lower prices per one dollar. However, although this scenario might be most likely, it is not the only one. And one has, at least, to mention the possibility of opposing scenarios. As it was explained, increase or decrease in the amounts of money is not a uniform process. There are individuals who are affected in the beginning and there are also individuals that are affected only later on. As a consequence, redistribution of resources takes place⁴⁷. In other words people are not equally well off after the results of changes in the amount of money are spread all over the economy as they would

47 Cf. for example Mises (1971, pp. 137 ff.).

have been without these changes. As a consequence, relative prices of different goods might differ. And this is an important point in this respect – changed relative prices could in the same way as it was explained in one of the sections above, bring about changes in quantities of pounds supplied and quantities of pounds demanded in the opposite direction one would expect. The present author does not deny the existence of a multiple arising questions in this respect. Like the following: How persistent changes in the exchange rate induced in this way be? What types of processes are put into play with these scenarios. Answering of these questions, is, however, to be left for other treatments.

2.2.4.2 Expectations and foreign exchange markets

The role of expectations in respect with the exchange rate theory is perpetually repeated in Mises’ works, at least since Mises (1971)⁴⁸. It should be noted, however, that Mises in this respect does not develop a comprehensive theory of expectations with some application for the exchange rate theory. Rather, he tries to raise one direct point: that in our present monetary system, changes in the quantity of money, and changes in the prices of money in general, tend to manifest themselves much sooner at the foreign exchange market rather than at many other markets:

“Under the modern organization of the monetary system this adjustment [of the prices of the commodities concerned in international trade to the new value of money] is usually first made on the Stock Exchanges.

Speculation on the foreign-exchange and security markets anticipates coming variations in the exchange ratios between the different kinds of money at a time when the variations in the value of money have by no means completed their course through the community, perhaps when they have only just begun it, but in any case before they have reached the commodities that play a decisive part in foreign trade.” Mises (1971, p. 214)

It should be stressed, however, that this is a point of non-aprioristic nature. It is not something that would automatically spring from the Mises’ praxeological system; it is a matter of facts related with the reality we live in, subjects of potential further investigations⁴⁹⁵⁰.

48 Cf., Mises (1996, pp. 455-456), Mises (2002, p. 35) and Mises (2000, p. 76).

49 One of the potential paths for these further investigations might be based on the fact that functioning of foreign exchange markets is strongly related with activities of specialized arbitrageurs and take centralized trading institutions.

50 This feature is then the cause of other redistributions – in case of the increase in the money supply and respective increases in the domestic prices and depreciation of the exchange rate, for example, exporters or foreign consumers tend to gain since they already reap benefits from the depreciated domestic exchange rate whereas the prices for which they buy their inputs or consumption goods are still not increased. More on this see Mises (1971, pp. 214-215) and Hayek (1999, pp. 61-73).