2. The Austrian Theory of Exchange Rates
2.1 Subjectivist theory and exchange rates: basic implications
2.2.2 Price Differentials and Exchange Rates
Until now, we have talked about general issues that are relevant for all participants and potential participants of the market for the foreign exchange, namely, valuation of Final Ends, and prices of goods purchasable by the foreign currency as well as prices of their domestic alternatives. In the present section, we would like to investigate rather a point that is on the one hand only a subordinate to the problem of prices investigated above, however, that on the other hand and at the same time is related with less restricted area. To be more precise, our investigations will be related with chains of actions that start with exchange of one currency for another and end up with the first currency in the hands of individual. This process is definitely related with phenomenon of changes in prices, although it does not encompass all of it, but it is also related with combinations of changes in multiple of prices, including future exchange rates.
In advance to the actual investigation, it will be useful to explain reasons for particular choice of this type of subject for the analysis. The reason is threefold. First, price differentials are observable at the market in contrast with bare subjective preferences and valuations. Analysis on their behalf, for example analysis based on the comparison of price differentials of competing alternatives, might be therefore found useful. Second, it is a matter of a fact that important amount of participants acting at the foreign exchange markets base their actions on comparisons of alternative price differentials, as their aim is to attain, ceteris paribus, the highest profit possible. Third, it is price differentials that are in an important way affected by various government policies. This, in concert with the previous point, makes a good reason to take them into account of the exchange rate analysis, as the government policy affecting these differentials might consequently bring about changes in the exchange rate.
In order to clarify the phenomenon of our concern, let us put it into the means-ends framework:
ER z money units
($) Corresponding
sets of actions y money units
(£)
Final End x money units
($)
ER z money units
(£) Corresponding
sets of actions y money units
($)
Final End x money units
(£)
Figure 19: Chains of actions and price differentials
Both schematic chains of actions in the figure above are of the same type. Starting with the decision of whether or not to exchange currency in possession for the other currency and ending up with some amount of the same type of currency as held in the beginning. In other words, individual is able to count the money spread of the chain of his actions and compare it with other chains of actions with the same property. For the sake of simplicity, from now on, we will be using in our examples only the first case of chains of actions – that starting with dollars.
There is a wide array of potential chains of actions that fit the framework depicted above. The first crucial question to be answered is, whether there is an important group of people in the economy who prefer higher monetary profit than otherwise in respect with the chain of action in question. If this is the case, than with increasing z, i.e. increasing amount of dollars that are to be obtained out of the initial decision to exchange dollars for pounds, increases the amount of pounds demanded at the exchange rate in question. With decreasing z, the opposite takes
place. For the time being, we will assume the existence of this group of people. If this is not the case, present analysis is not much applicable for explanation of aggregated supply and demand schedules related with the foreign currency.
The general principle is thus clear. The question is, what types of systematic influences could bring about change in z. And this question brings us directly to the need for a more precise clarification of the content related with the “Corresponding sets of actions”. Two general possibilities will be discussed in this respect. First, where the future exchange rate will be involved and second, that does not involve further participation at the foreign exchange market.
ER z money units
($) Corresponding
sets of actions y money units
(£) Final End
x money units ($)
The content of the “Corresponding sets of actions”
P1 P2 ER2
z money units ($) w money
units (£) sets of goods
+ production y money units
(£)
Figure 20: Price differentials and exchange rates, scenario number 1
It has already been stated that it is z/x ratio that is of importance in this context. Our question now stands: “What affects this differential for exchange rate in question?” This is addressed by the picture above. Three types of prices are highlighted: First, pound price (P1) of goods that will be purchased for the obtained foreign currency. Second, pound price of goods that are to be sold as a result of the previous purchase (P2). Exchange rate (ER2) at which the obtained currency from the chain of actions presently discussed will be exchanged for the domestic currency.
Let us start with P1. It is clear that not only one type of good but also a multiple of goods could be purchased for the sum of y£. P1 therefore stands rather for a sum of money spent on
the multiple of goods. It should be stated clearly that these „goods“ are referred to in the broadest sense of the word, therefore including also factors of production, interest bearing securities or money at the bank accounts. The important point is, however, that other things being equal, the lower is P1, the higher is z/x, and a vice versa. Similar point could be made in respect with P2. The higher P2 is, the higher is also z/x, and the lower P2 is, the lower is z/x.
It should be clearly stated at this point that one should not confuse (P2-P1)/P1 with the interest rate that is paid in the country. The production process we are discussing could involve also goods that have not been purchased for pounds, i.e. domestic goods. One could for example purchase bananas and pears for pounds in order to prepare salad and to sell it for pounds. One of the ingredients could be, however, recipe that is paid for in dollars. The selling price in pounds is therefore expected by the seller to cover not only the costs of the goods paid for in pounds, i.e. bananas and pears, but also those paid for in dollars, i.e., recipe.
Moreover, required interest rate also differs from entrepreneur to entrepreneur and is a matter of subjective valuation, important point in our case is the change in the differential that makes the whole transaction more or less attractive, i.e. bringing increasing or decreasing amount of pounds demanded at the exchange rate in question.
Let us now talk more about the ER2 phenomenon. It clearly influences the amount of z.
Increase in the exchange rate (depreciation of dollar) increases the z/x ratio ceteris paribus increases the amount of pounds demanded at the ER1. Decrease in the ER2 leads to the opposite reaction.
One might argue that we are now involved in a vicious circular reasoning, explaining the phenomenon of exchange rate (ER1) by the phenomenon of exchange rate (ER2). This is not the case, however. In all points of time, exchange rate is not an end in itself. It is rather a manifestation of voluntary exchange – it is price. To put it in different words, it is a part of some chain of actions with some Final End. We do not know these ends, although we might have some idea in this respect, however, there is no reason for people to exchange at some particular exchange rate unless this transaction is not believed to lead to their desired end.
Consequently, future exchange rate have to be explainable by some end factor that is not exchange rate itself. It is true, some future change in the exchange rate might be put in explanation forward to even more future change in the exchange rate, however, despite of the
fact how long is this explanation based on chains of future exchange rates, there has to be some other “end” reason in the end that could explain this very last shift in the exchange rate.
The summary of the effects discussed for the holders of dollars as well as for holders of pounds in respect with the situation at the foreign exchange market is summed in the following tables:32
Holders of dollars
Price Currency Type of change
Effect on the quantity of
£ demanded P1 £ increase decrease P1 £ decrease increase P2 £ increase increase P2 £ decrease decrease ER2 $ increase increase ER2 $ decrease decrease Holders of Pounds
Price Currency Type of change
Effect on the quantity of
£ supplied P3 $ increase decrease P3 $ decrease increase P4 $ increase increase P4 $ decrease decrease ER2 $ increase decrease ER2 $ decrease increase
Table 20: Price differentials and changes in quantities of pounds supplied and demanded, scenario number 1
We could turn now our attention to the second option, one that does not include other exchange rate than the one to be explained (see Figure 21).
The effects in this case are clear: as it is the z/x ratio that is of importance, increase (decrease) in P1 ceteris paribus decreases z. Consequently, increase (decrease) in P1 brings about decreased (increased) amount of pounds demanded. On the other hand, increase in P2, i.e.
selling price of the production process, brings about the opposite reaction - increase in the quantity of pounds demanded. Decrease in P2 then brings about decrease in the quantity of pounds supplied.
32 P3 stands for the dollar buying price of factors of production, P4 for the dollar selling price of the product.
ER z money units ($) Corresponding
sets of actions y money units
(£)
Final End x money units
($)
The content of the “Corresponding sets of actions”
P1(£) P2 ($)
z money units ($) sets of goods
+ production y money units
(£)
Figure 21: Price differentials and exchange rates, scenario number 2
The summary of the analysis could be found in the tables below:
Holders of dollars
Price Currency Type of change
Effect on the quantity of
$ demanded P1 £ increase decrease P1 £ decrease increase P2 $ increase increase P2 $ decrease decrease Holders of Pounds
Price Currency Type of change
Effect on the quantity of
$ demanded P3 $ increase decrease P3 $ decrease increase P4 £ increase increase P4 £ decrease decrease
Table 21: Price differentials and changes in quantities of pounds supplied and demanded, scenario number 2