Vysoká škola ekonomická v Praze
Národohospodá ř ská fakulta
Hlavní specializace: Hospodářská politika
Austrians and the Mainstream: The Stories of Exchange Rate
Determination
diplomová práce
Autor: Šimon Biľo
Vedoucí práce: Ing. Jan Havel, Ph.D.
Rok: 2008
Prohlašuji na svou čest, že jsem diplomovou práci vypracoval samostatně a s použitím uvedené literatury.
Šimon Biľo
V Praze, dne 8. 5. 2008
Abstract
The scope of the present thesis is four-fold. First, to clarify and explain the means-ends framework and step-by-step analysis of the Austrian school. Second, to apply this framework to the Austrian theory of exchange rates. Third, to link the framework with most of the existing Austrian research related with the exchange rate theory and discuss this research.
And fourth, to confront the Austrian economics with two mainstream approaches - Dornbusch’s overshooting model and short-run portfolio balance model. Message springing from this confrontation is twofold. First, the fundamental differences between present-day mainstream methods are envisaged. And second, the fact of possibility of mutual enrichment of both approaches from each other despite of completely different methodological backgrounds is suggested.
Anotácia
Obsah tejto práce je možné zhrnúť v štyroch hlavných bodoch. Po prvé, objasnenie prístupu Rakúskej ekonómie založenom na konceptoch prostriedkov a cieľov. Po druhé, aplikácia tohoto prístupu na problematiku menových kurzov. Po tretie, prepojenie zistení z predchádzajúceho bodu s podstatnými prínosmi Rakúskych ekonómov v oblasti teórie menových kurzov. A po štvrté, konfrontácia prístupu Rakúskej ekonómie a dvoch prístupov hlavného prúdu ekonomickej vedy.
Table of Contents
Introduction ... 4
1. The General Austrian Framework... 5
1.1 The means-ends framework ... 5
1.2 Chains of actions ... 6
2. The Austrian Theory of Exchange Rates ... 7
2.1 Subjectivist theory and exchange rates: basic implications ... 7
2.1.1 Notation... 7
2.1.2 Initial Assumptions and the Means-Ends Framework ... 8
2.1.3 The Process of Valuation Within the Means-Ends Framework... 9
2.1.4 Valuation and Exchange Rates... 10
2.1.5 Valuation of ends and the supply and demand apparatus at foreign exchange markets 11 2.2 Subjectivist theory and exchange rates: advanced considerations ... 26
2.2.1 Valuation and Prices... 27
2.2.2 Price Differentials and Exchange Rates ... 44
2.2.3 Inter-local price differences and (non)changes in exchange rates ... 49
2.2.4 Exchange rates and changes in the money supply ... 52
2.2.5 The Austrian exchange rate theory: mistakes of Mises and Salerno... 58
3. Austrians and two selected mainstream theories... 64
3.1 The Dornbusch Sticky-Price Monetary Model (SPMM) and Austrian Insights.. 64
3.2 Austrians and Simple Portfolio Balance Model (PBM)... 69
Conclusion... 73
References ... 74
List of Figures ... 76
List of Tables... 77
Introduction
During about first six decades following the marginalist revolution, most of the proponents of the new paradigm in the theory of value had an impression that although there are very important differences among existing marginalist traditions, there is some fundamental common ground for economic theorizing. It was only later, namely as a consequence of – then progressing – debate concerning the possibility of economic calculation under socialism1 when the proponents of the Austrian school fully realized fundamental methodological difference between themselves and most other traditions2. They suddenly found themselves
“out” of the mainstream and finally more or less “out” of the most important journals.
It is not scope of this paper to analyze the issues of rise, fall, and recent “underground” revival of the Austrian school of economics. Nor we will try to solve the fundamental methodological debate led by Austrians in respect with most other current traditions. The important point for us is that there is such a difference and our aim, based on this fact, will be more humble: we will try to understand specific application of the Austrian theory with respect to the exchange rate determination and highlight its differences with set of more recent explanations of this phenomenon. There are at least three good reasons why this end is to be found useful and important: first, original Austrian point of view on the topic, view now mostly neglected and forgotten, will be highlighted and made accessible to the non-Austrian reader; second, while analyzing the mainstream apparatus with Austrian “tools”, selected mainstream theories will be made accessible to the Austrian reader; and finally, by pointing out the backgrounds and crucial differences between presented theories, critical comparison of competing approaches will be provided.
Present paper is divided into five sections. The second one is devoted to the formulation of the most important tenets of the Austrian tradition that will be required in course of our investigation. Third part will concern the actual presentation of the Austrian exchange rate theory. In the fourth part, two mainstream theories – Dornbusch’s overshooting model and short-run portfolio balance model, will be shortly presented and then contrasted with the Austrian framework. Finally, conclusions will be presented.
1 Cf. Hoff (1949).
2 See for example Salerno (1999).
1. The General Austrian Framework
Every explanation of a phenomenon of our reality is necessarily rooted in the approach chosen. This statement is no less true in case of foreign exchange rate theory than in other cases. It is therefore natural to begin our analysis with “roots” of the Austrian approach.
Since the times of Carl Menger3, the founder of the tradition, Austrian economists refer to the categories of cause and effect4 as sine qua non of their world-view. They claim that it is only the causal insight, in the broadest sense of the word, which could lead us to understanding of the world around us; no other comprehensive perception of reality except explanation of one phenomenon brought about by another phenomenon is opened to human mind.
Applying these considerations to economics, present-day Austrians link most observed effects that are to be explained to the ultimate cause of human action, where human action is defined as purposeful behavior of an individual. It is the fact that humans act – the fact one cannot reject without implicitly presupposing it, which implies presence of scarcity and the law of diminishing marginal utility; which explains valuation of individuals – ordinal ranking of goods on value-scales; and which could be traced back as the main cause of most important propositions of the economic science. Economic theory or catallactics, the main concern of which is the study of the market phenomena, is thus rooted in the general theory of human action – praxeology5.
1.1 The means-ends framework
The role of causality in the Austrian analysis has been already stressed. The very use of the concept of human action represents clear demonstration of this fact. However, there is also another dimension of causality’s crucial role that is implied by the very use of the concept of action: humans act, i.e., they behave purposefully, only if they assume that their action could lead to the purpose envisaged. This is feasible only if certain things under certain conditions could be expected to lead to the desired purpose6. Only if people could expect causal nature of
3 See especially Menger (1994).
4 First sentences of Menger’s Principles are illuminating: “All things are subject to the law of cause and effect.
This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary.” in Menger (1994, p. 51). Cf. Mises (1996, pp. 22-29).
5 For elaborate Austrian methodological works see for example Hoppe (1995), Mises (1996), Mises (2003), and Rothbard (2004).
6 “In a world without causality and regularity of phenomena there would be no field for human reasoning and human action. Such a world would be a chaos in which man would be at a loss to find any orientation and guidance.” Mises (1996, p. 22). Cf. Mises (1996, pp. 22-23), and Hoppe (1995, pp. 17-21).
our world, they could act: they are able to use things which they regard as suitable – means, in order to attain states of affairs that they regard desirable – ends. Consequently, the very category of means and ends then stands and falls on the category of cause and effect.7
1.2 Chains of actions8
Following the means-ends framework, it is of highest importance to point out the fact that particular actions are parts of more complex action-frameworks: plans. This holds true for an individual himself as well as for cases of interpersonal cooperations. It is true that this does not directly spring from the action axiom. However, it is a fact of the world we live in that this is the case: time horizon of individual overreaches his next fraction of breath; and our society is based on the division of labor. How precisely are then both mentioned frameworks – interpersonal chains of actions and individuals’ chains of actions, to be understood?
Concerning the individual’s level9, most actions are not undertaken for their own sake, i.e., they are not only ends in themselves. On the contrary, they serve as a part of some plan with higher time horizon. It is the final stage of the fulfillment of this plan that represents the end10. This is not to say that each action necessarily leads only to one end in some future point in time. It is often possible to provide actions that are suitable for successful accomplishments of more plans, and consequent attainment of more ends that are not necessary distributed in the same time. The important point is that action usually appears to actor in some context of ends and other actions.
The following figure stands for a schematic illustration of individual’s chain of actions:
End Stage 1 Intermediary
Stage 3
Intermediary Stage 2 Present state
of individual
Figure 1: Chain of individual’s actions
7 Mises (1996, p. 22).
8 The term “chain” and its understanding is based on the analysis of Hayek (1999).
9 For elucidation of this see Soto (2005, pp. 266-269).
10 It should be clarified at this place what this “ultimate end” represents:
“[T]he ultimate ends of human action are not open to examination from any absolute standard. Ultimate ends are ultimately given, they are purely subjective, they differ with various people and with the same people at various moments in their lives.” (Mises (1996, p. 95).
In other words, what the end represents is specific to each individual in given time: “Strictly speaking the end, goal, or aim of any action is always the relief from a felt uneasiness.” (ibid., p. 92).
Here, an individual from his present state has already chosen the end that he is willing to attain. Schematically, this comprises a set of actions that have to be undertaken in an order represented by the arrows. In fulfilling these actions, one is getting closer to the final end – via attaining intermediary stages11; the number of the stage represents ordinal remoteness from the consumption – attaining of the Final End (Stage 1)12.
2. The Austrian Theory of Exchange Rates
2.1 Subjectivist theory and exchange rates: basic implications
As it was already noted, it is the willingness to trace the social phenomenon back to individuals and their actions that stands for a basic landmark of the Austrian analysis. The systemization of the Austrian exchange rate theory correspondingly should prove to be able to fulfill this methodological obligation. The approach chosen will lead from the most basic postulates of the value and price theory to more restricted phenomena linked with the exchange rate theory.
In advance to the actual execution of the task, it is necessary to clearly formulate the problem we seek to solve by the exchange rate theory: “Let us assume two fiat currencies, each used in a separate region. How do we explain the price of one currency in terms of another currency?”
Or, in other words: “Why is it that people are willing to pay such and such amount of one currency for a given amount of another currency?”13
2.1.1 Notation
In course of the following text, some illustrative examples will be provided. Unless stated otherwise, two separate monetary regions will be assumed, each having one distinct fiat currency. For the one region, it will be dollar ($) and for the other, it will be pound (£). While the dollar is assumed to be the “domestic currency”, pound will be tagged as the “foreign currency”. Unless stated otherwise, the exchange rate is expressed in what is usually referred to as a direct quotation from the point of view of dollar holders – number of dollars per one
11 It should be noted that delineation of „Stages“ is important from the perspective of economist who chooses particular achievements of the chain of actions that are important for his analysis.
12 This convention of ascribing of stages of production – production goods, in accordance with their remoteness from the final consumption is employed since Menger (1994). Cf. (ibid., pp. 55 ff.), Mises (1996, pp. 93-94), Böhm-Bawerk (1959, pp. 168 ff.).
13 The reason why we deal only with the case of „fiat currencies an separate regions” in this work is purely practical – to narrow down the scope of the analysis. As the majority of present day monetary systems is fiat and regionally exclusive, the selection appears to be accurate under the criterion of the “usefulness for the understanding of the real world”.
pound ($/£). As a consequence, dollar is appreciating when the exchange rate declines, for example from 2$/£ to 1$/£, and it is depreciating with rise of the exchange rate, for example from 3$/£ to 5$/£.
2.1.2 Initial Assumptions and the Means-Ends Framework
Our analysis will be based on the assumption that both – domestic currency and foreign currency – are valuable economic goods. In the contrary case, there would be no need for explanation of the price of these two currencies, as there would be no price to be explained. In addition, we assume these currencies to stand for a standard function of a “medium of exchange”14 in their home countries.
In accordance with what has been said above, we assume two distinct monetary areas. People there value currencies – dollars and pounds – because they know, or assume to know, that they are means suitable for attainment of various ends: there is a desirable state of affairs – end – that is dependent on the possession of the unit of currency in question. Following the basic general means-ends framework proposed above, people could percept possession of dollars in the following way:
corresponding sets of actions
End A x money units
($)
Figure 2: Chain of individual’s actions: dollars
Mutatis mutandis, the same framework could be applied for possession of pounds:
corresponding sets of actions
End B x money units
(£)
Figure 3: Chain of individual’s pounds
The framework above holds for all dollars and pounds. As they are economic goods, all of them represent means that are used for attainment of some end. Moreover, the fact that they are economic goods is related with another important fact – they are scarce, i.e., they, as means, could not attain all valuable ends people would be willing to reach with them. In other
14 For Austrians, money is first and foremost medium of exchange. All other “functions” of money are only of secondary and/or derivative importance. On this point see for example: Menger (1892), Menger (1994), Mises (1971), Mises (1996), Rothbard (2004). That this approach is kept on mind also by some current mainstream economists see King (2004, p. 2).
words, there are competing uses of money and people are forced to choose between these uses, i.e. between ends represented by these uses15.
2.1.3 The Process of Valuation Within the Means-Ends Framework
We have reached the point, where it is necessary to explain consequences of the necessity of choice referred to above. As people choose between competing ends attainable by the sum of money in question via choice in means, they ascribe relative value to these ends, and consequently to means leading to these ends. One end has to be regarded as more important when compared to all other competing ends. It is thus natural to broaden our means-ends framework with the aspect of choice between competing ends and put it into the context of valuation:
State of affairs Corresponding sets of actions
End A
x money units ($)
Corresponding sets of actions Alternative
state of affairs End C
Figure 4: Chains of individual’s actions: valuation
The picture ascribes a scenario of two competing ends – End A and End C16. In his decision making point, we assume one to choose between a State of affairs and some Alternative state of affairs. Both of these are believed to lead to one of the two competing final ends. If we assume that one values benefits from attaining the State of affairs higher when compared with benefits springing from the Alternative state of affairs, then the State of affairs will be valued higher (and chosen respectively) over the Alternative state of affairs. On the other hand, if one prefers End C to End A, one correspondingly chooses the Alternative state of affairs instead of the State of affairs.
It should be noted, however, that the example does not necessary have to stand for a rather unrealistic situation where actor faces two competing ends only. The Alternative state of
15 Cf. Menger (1994, pp. 51 ff.).
16 The graphical illustration of two Ends in different points of time just stresses the fact that these two do not have to happen in the same time period, although there is no reason for why could not.
affairs might represent all other potential alternative ends. That only one of them is portrayed at the picture could be justified by the fact that we stress comparison of the end in question (End A in our example) with the most important competing end (which could be represented by the End C of our example).
2.1.4 Valuation and Exchange Rates
We are now coming closer to the question proposed in the beginning: “Why do we exchange given amount of one currency for a given amount of another currency?” The basic means- ends relationship that is related with the question is presented in the picture below:
y money units (£)
Corresponding sets of actions
End D x money units
($)
Figure 5: Chain of individual’s actions: foreign exchange market
The point of the picture is simple, however, very important: there is only one potential reason of one’s purchase of a currency for another currency. That is, to attain the dependent end that is linked with the other currency.
Concerning the process of valuation, the case of exchange rates is in principle the same as any other decision-making:
y money units (£)
Corresponding sets of actions
End D
x money units ($)
Corresponding sets of actions Alternative
state of affairs
End E
Figure 6: Chain of individual’s actions: valuation at the foreign exchange market
The answer to the question of whether we are apt to exchange given amount of one currency for some given amount of another currency is dependent on the valuation of ends rooted behind these decisions. If the End D, that is in the eyes of the actor dependent on this
exchange, is more valuable than the highest valued alternative - End E, the exchange might take place. On the other hand, if the contrary is the case, the exchange of one currency for the other does not take the place. Or at least, it will take place under different conditions that are represented by the alternative end (End E).
It should be noted that we would have to introduce at least one other person possessing the other currency to be able think the “exchange” of currencies at all. And in fact, we did it tacitly in the previous example by bare enabling the bare possibility of the exchange of one currency for another. After this quick and restricted illustration of interdependence of valuation of ends with actual valuation of means at the field of exchange rates, we will broaden our analysis. It is important to use the basics of the theory of value for introduction of a systematic apparatus of supply of dollars, i.e., demand for pounds, and demand for dollars, i.e., supply of pounds.
2.1.5 Valuation of ends and the supply and demand apparatus at foreign exchange markets
2.1.5.1 Introductory remarks
Let’s reproduce once again Figure 5 from the above:
y money units (£)
Corresponding sets of actions
End D x money units
($)
Figure 7: Chain of individual’s actions: foreign exchange market
Until now, we have been talking about some given end (End D at the present picture), given amount of domestic money (x) and given amount of foreign money (y). Under these assumptions, in case that the end is sufficiently attractive, person making the decision is willing to exchange the money at the given exchange rate. In the opposite case, the transaction does not take place. Although this point of view reveals some important insights, it definitely does not represent complex treatment of the problem. And it is time to make some further steps in this respect.
Our analysis will start again with the fact already repeatedly stressed, namely, that there is a necessity for existence of some End behind actual actions at foreign exchange markets. A multiple of questions arise with closer look upon the existence of this End, however.
First, one could claim that it does not have to be only one “End”, one is willing to attain with means of the foreign currency purchased at one instance. In other words, Mr. Jones could for example plan to purchase 1000£. However, one might point out that there could be a multiple of ends to be attained by means of this foreign currency. Mr. Jones might intend to spend part of this sum for a car rental (500£), and the other part might be independently in respect with this purpose designated for purchases of other foreign goods – like those of food, electronics, etc. Although it is true that such distinction might be possible and at some point of the discussion also reasonable, we are now looking for the reasons why one at the given moment offers certain amount of domestic currency in exchange for the certain amount of the foreign currency. Whether this reason actually consists of purchases that could be distinguished in some functional or temporal way is irrelevant for this purpose. At the moment of purchase, this set of multiple “Ends” is regarded on the one hand as in its totality and is compared with all other potential alternative ends and finally is regarded as the most important one. For the sake of this concrete purchase, it therefore represents one sole End and it will be treated as such in this respect17.
Our second remark will be related with the fact, that there are usually not only two conflicting options in one’s decision making, as some of the previous pictures could have potentially misleadingly suggested. We should fully open our investigation for situations where multiple conflicting ends arise as well as for situations where varying amounts of foreign and domestic currency could be demanded and supplied. In fact, this is the only way in which one could possibly employ supply and demand analysis.
Third, it is the fact that the very same end that could be defined in the same physical terms (in fact by the same means leading towards it), could be valued differently, i.e. its valuation might be subject of change in the eyes of a person making the decision. The case where an apple is valued higher to an orange might be thus, for example, contrasted to the situation, when the opposite is the case. This point has been already touched in the previous sections18,
17 Cf. section 1.2 above.
18 Cf. section 2.1.4 of this work.
our question, however, is: “What are the possible consequences of changes in valuation for the supplied and demanded quantities of respective currencies at the foreign exchange market?”
And it will be this third point that will be of our main interest in course of the present section.
Namely, we will try to pint out possible implications of changes in the relative valuation of ends. Analysis of these implications will be provided for the case of individual, as well as for the foreign exchange market with presence of a multiple of individuals. An important note should be made at this point, however. It is just a matter of a fact that prices of foreign goods as well as those of domestic goods play an important role in course of the decision-making of individuals in respect with the foreign exchange market. Moreover, it is undisputable that these decisions themselves do have effects on prices of goods. At the present point, we would, however, like to avoid discussions in this respect, assume prices to be given, and leave the analysis for the following sections. It is true, one might coin this treatment as arbitrary, however, present author opines this distinction between the influence of valuation and the influence of prices to be useful, as economics treats causes of these two influences differently.
On the one hand, change in the valuation of the good is a datum that is ultimately given for economist19. Other sciences might very well contribute to potential explanations of this phenomenon, however, economic analysis starts with the fact of given preferences. On the other hand, price stands for a fact to be explained by economics. This means economics, has, or at least potentially could have, something to say on the changes in price that eventually affects the exchange rate. As these two important influences – preferences and prices – do have a different background in this respect, it seems suitable from this aspect to treat them, at least to some extent, separately.
Our aim for the remaining parts of the present section is therefore clear-cut: creation of the supply and demand framework of the foreign exchange market, while assuming prices of goods kept intact, and investigation of the results of changes in valuation of ends related with actions on the foreign exchange market.
2.1.5.2 Individual demand
19 Cf. (Mises (1996, p. 95).
Let us first start with the situation of an individual – Mr. Smith. As we are considering the impact of the valuation of ends on the exchange rate, it is extremely important to treat ends in an appropriate way. What are the important points in this context?
First, we know that there is some given amount of domestic currency in Smith’s hands that will be divided into two parts – a part that will be supplied in exchange for the foreign exchange and a part that will not be supplied at the foreign exchange market.
Second, we know that Smith is aiming to attain the most important state of affairs with the sum of money at his disposal. At the most general level, this means that he puts together bundles of achievements, or partial Ends, that could be attained with his means and compares competing bundles with each other. From now on, we will call these total sets of achievements just “Final Ends”.
Third, it is important to systemize decisions concerning the individual’s allocation of money in respect with our analytical needs. As our primary aim is to understand quantities demanded and supplied at the foreign exchange market and as these quantities depend on the fact whether goods to be attained are to be pursued with the domestic currency or with the foreign currency, our criterion will be corresponding: we will distinguish between “Particular Foreign Exchange Ends” (PFEE) and “Particular Domestic Exchange Ends” (PDEE). Both of these are represented by obtaining of respective goods: domestic – the case of PDEE; and foreign – the case of PFEE. It should be clear that goods representing PFEE and goods representing PDEE together represent the “Final End”. Whatever is the case – whether the domestic and foreign goods are actually used in separate actions or rather used together – is of no importance for our investigations. The important point is that all goods – foreign and domestic – that are intended to be attained together, represent a bundle, Final End, that competes with other alternative bundles, alternative Final Ends.
For the sake of clarification, we will use our framework in order to stress the fact that from the current amount of currency at one’s disposal, one decides the amount that will be exchanged for the foreign currency. We should still keep on mind, however, that the
alternative state of affairs might stand for some exchanges at the foreign exchange market as well; just with a different Final End pursued20:
Final End 1
Final End 2
Alternative state of affairs
PFEE Corresponding
sets of actions
PDEE Corresponding
sets of actions w money units
($) y money units
(£)
x money units ($)
Corresponding sets of actions
Figure 8: Chain of individual’s actions: valuation at the foreign exchange market and particular ends
Fourth, what is important to keep in mind is the fact, that in order to be able to make decisions that could lead to the highest possible Final End, Mr. Smith necessarily needs to have expectations of monetary costs of respective particular ends (as well as costs of goods leading to them): in dollars for those of PDEE and in pounds for those of PFEE. In the opposite case – in the case of not being aware about the costs of means purchasable by the two currencies, Mr. Smith would just not be able to assess the relative importance of respective currencies as means that are suitable for attainment of respective Ends. For the sake of the present section, however, these prices are assumed to be “given”.
Let us now turn the attention to the concrete situation of Mr. Smith, presently holding 30$ at his disposal. Mr. Smith is just at the point of deciding concerning the quantity of pounds to be purchased. Given his assumptions of foreign and domestic prices, his preference scale and derived individual demand schedule could be portrayed as follows21:
20 In order to stress the fact of possible variability of what the alternative state of affairs stands for, we left the graphical content of the elipsis for the Final End 2 blank.
21 The following part as well as other parts of the present work make use of the preference scale analysis. For some of the most important contributions in respect with this approach cf. Böhm-Bawerk (1959), Menger (1994), Rothbard (2004).
The Preference Scale of Mr.
Smith 10 $
first obtained £ 9$
8$
second obtained £ third obtained £ 7$
6$
fourth obtained £ 5$
fifth obtained £ sixth obtained £ 4$
3$
2$
Demand Schedule of Mr. Smith Price ($/£)
Quantity of £ demanded
10 0 9 1 8 1 7 3 6 3 5 4 4 6 3 6 2 6
Table 1: The preference scale of Mr. Smith and corresponding demand schedule
The preference scale shows Mr. Smith’s relative valuation of additional relevant units of pounds (in our case, it is 1£) in respect with the relevant unit of dollars (in our case, it is 1$).
The individual demand schedule sums up the information of the preference scale. The later is often put into a graphical form as a demand curve, like the one in the picture below.
0 2 4 6 8 10 12
0 1 2 3 4 5 6 7
Quantity of pounds (units)
Price ($/£)
Figure 9: Curve representing demand for pounds of Mr. Smith
The question is of course, why Mr. Smith intends to do what he intends to do under the given conditions? The most basic answer would be purely based on the law of decreasing marginal utility22. On the one hand, each additional unit of pounds, as far as the unit is chosen appropriately23, is used only in employment for some less important designated use than the previous unit; while on the other hand, each additionally given up unit of dollars is withdrawn from the more important designated use than the previous unit. With increasing amount of pounds at disposal, its marginal utility, i.e. relative valuation in respect with dollars, decreases and with decreasing amount of dollars, the marginal utility of a dollar increases, i.e. dollars have to be withdrawn from employments that are expected to secure more and more important ends. This is the reason why additional units of pounds will be purchased only at lower dollar prices per unit. Our investigation goes into more detail, however. We are interested in actual influence of ends that lay behind respective decisions on the exchange rate. The following table gives us a possible scenario:
Domestic Particular Ends attained
(PDEE)
Amount of $ at Smith's disposal
The Preference Scale of Mr.
Smith's
Amount of £ at Smith's disposal
Foreign Particular Ends attained (PFEE)
PDEE 1A 30 10 $ 0 -
PDEE 2A 21
first obtained
£ 1 PFEE 2A
9$
PDEE 3A 22 8$ 1 PFEE 3A
PDEE 4A 16
second
obtained £ 2 PFEE 4A
PDEE 5A 9
third
obtained £ 3 PFEE 5A
7$
Figure 10: Background of the sequence of the preference scale of Mr. Smith
Aim of the picture above is to examine selected sequence of the preference scale represented by the Table 1 – particularly to examine its range between 10$ and 7$, and to put it into the context of ends that are rooted behind Mr. Smith’s decisions. Each filled row24 stands for the best possible Final End, i.e., constellation of particular ends PFEE and PDEE, attainable at the given exchange rate. For the time being, the “Final End” related with “PDEE 2A” and “PFEE
22 Cf. for example Mises (1996, pp. 119 ff.), or Rothbard (2004, pp. 21 ff.).
23 Cf. Rothbard (2004, pp. 72 ff., and 311 ff.).
24 Blank rows are caused by the fact that we assume the scenario proposed for the given price of the preference scale has been already dealt with in the row below or in the row above.
2A” will be called “Final End 2A”; “Final End” of “PDEE 3A” and “PFEE 3A” will be called
“Final End 3A”; and so on.
In the first row, that represents exchange rate of 10$/£, Mr. Smith assumes that spending of all the money at his disposal (30$) in the domestic country leads to the highest attainable final end – Final End 1A. Goods that could be purchased for the foreign currency are just too expensive in terms of dollars: ends that they lead to have lower value than ends that would have been lost lower purchases of goods and services for the domestic currency. Let us say that the least desirable of the purchased domestic goods that is represented by 10$ is a sack of 10 apples. On the other hand 1£ that could be potentially purchased for 10$ might bring about 2 oranges – the highest valued PFEE from those that are possibly attainable under the conditions. Mr. Smith’s preference scale is, however straightforward in this respect: 10$ that represent a sack of 10 apples is valued higher than 1£ that represents 2 oranges, as Mr. Smith values 10 apples higher than 2 oranges. If Mr. Smith did this transaction, he would attain some PDEE 1B in respect with domestic ends and PFEE 1B in respect with foreign ends. The Final End 1B that is related with the choice of PDEE 1B and PFEE 1B is, however, valued lower than the actually chosen Final End 1A.
Let us examine the second row now. Here, the exchange rate is 9$/£. Mr. Smith is under these conditions willing to purchase 1£. This means that goods that is Mr. Smith willing to obtain for 1£ - in our example goods that represent PFEE 2A – are more valuable than goods that could be purchased for 9$. To follow up with the previous example, sack of 8 apples that could be purchased for 9$ is worth less in the eyes of Mr. Smith than 2 oranges that could be purchased for 1£. As a consequence, Mr. Smith for this situation chooses PFEE 2A and PDEE 2A. It is clear that the very same logic that guided us in course of our explanations of the first two rows is applicable to all other rows in the table.
As we know much more about the determinants of the demand for pounds at the foreign exchange market, we could approach the question of potential consequences of changes in one’s valuations in respect with demanded quantities for particular exchange rates. The basic logic could be explained with help of the picture reproduced from one of the sections above.
y money units (£)
Corresponding sets of actions
End D
x money units ($)
Corresponding sets of actions Alternative
state of affairs
End E
Figure 11: Chain of individual’s actions: valuation at the foreign exchange market
Let us say that one is considering his actions under a particular exchange rate. It is clear that every monetary unit spent – either dollar, or pound – has costs in terms of purchases in the other currency. In other words, one always chooses between different competing bundles of PFEEs and PDEEs. In the framework of the picture above, this choice between bundles could be represented by the choice between two most important ends at hand: End D and End E.
Alternative state of affairs represents here abstention from use of dollars in question at the foreign exchange market. In case of relative increase in value of End D in respect with End E, the number of demanded pounds at the exchange rate in question comparatively increases in contrast with the opposite case.
We could illustrate the situation of increase in the quantities of pounds demanded at the case of Mr. Smith. Let us say, that at the exchange rate 10$/£, he now prefers 2 oranges to 10 apples. Moreover, that he would be willing to demand more pounds at the exchange rates of 9$/£ and 8$/£ for some similar reason. What would be the consequence for the demand schedule? The quantity demanded at the exchange rate of 10$/£ would increase from 0 to 1 with respective shift of the demand curve to the right at the given price.
Demand Schedule of Mr. Smith
$/£
Former Quantity of £ Demanded
Quantity of £ Demanded after the changes in valuation
10 0 1 9 1 2 8 1 2
7 3 3
6 3 3
5 4 4
4 6 6
3 6 6
2 6 6
Table 2: Change in the demand schedule of Mr. Smith as a consequence of the change in valuation of his ends
0 2 4 6 8 10 12
0 1 2 3 4 5 6 7
Quantity of pounds (units)
Price ($/£)
Figure 12: Change in the demand schedule of Mr. Smith as a consequence of the change in valuation of his ends
The table and respective figure above both show the result of change of preferences of Mr.
Smith. The general conclusion in this respect is clear. Relative increase in importance of ends that could be satisfied by the foreign currency in respect to those obtainable by the domestic currency increases respective quantities demanded for the foreign currency.
2.1.5.3 Individual supply
We will now introduce supplier of pounds – Mr. Brown. We assume that Mr. Brown is in a reverse position to that of Mr. Smith. In other words, he is willing to supply pounds, i.e.
demand dollars.
His preference scale, supply schedule with corresponding supply curve could then have the following form:
The Preference Scale of Mr.
Brown Supply Schedule of Mr. Brown
5$ $/£
Quantity of £ supplied
sixth 0,5 of given up £ 10 3
4$ 9 2,50
fifth 0,5 of given up £ 8 2,50
3$ 7 2
2$ 6 2
fourth 0,5 of given up £ 5 2 third 0,5 of given up £ 4 2
1$ 3 1
second 0,5 of given up £ 2 1 first 0,5 of given up £
Table 3: The preference scale of Mr. Brown and corresponding supply schedule
0 2 4 6 8 10 12
0 0,5 1 1,5 2 2,5 3 3
Quantity of pounds (units)
Price ($/£)
,5
Figure 13: Curve representing supply of pounds by Mr. Brown
Preferences of Mr. Brown and respective supply of pounds could be derived in the same way as those of Mr. Smith. Mr. Brown always aims to reach the highest Final End possible, and for each relevant exchange rate, he looks for the most suitable combination of foreign ends (PFEE) and domestic ends (PDEE). Potential appreciation of pound (increase in the exchange rate) makes attaining ends with dollars as means less costly in terms of ends that could be attained with pounds: more dollar-ends could be attained at the same pound-price. To put it in different words: With increasing amount of pounds that are potentially supplied at the foreign exchange market, the forgone marginal utility of a pound (or its relevant multiple or fraction)
increases. With increasing number of dollars in possession, the marginal utility of dollar decreases. As a consequence, holders of pounds need more dollars per pound to be offered, more potential ends to be satisfied by dollars, in order to give up additional pounds. As a consequence, the supply curve is increasing in the left-right direction.
In respect with changes in preferences, the question is, whether the relative preference for potential foreign ends that could be attained at the given exchange rate increases or whether the relative preference for potential ends that could be undertaken decreases. In the former case, the supply curve at the given point “shifts” right, in the in the later case, it “shifts” left.
2.1.5.4 Foreign exchange market of two individuals
We have now two individuals – Mr. Smith and Mr. Brown – at the market. Let us visualize the their preference schedules together first:
Price ($/£)
Mr. Brown's supplied quantity of £
Mr. Smith's demanded quantity of £.
10 3 0
9 2,50 1 8 2,50 1
7 2 3
6 2 3
5 2 4
4 2 6
3 1 6
2 1 6
Table 4: Two individuals at the foreign exchange market: supply schedule and demand schedule
As the highlighted rows in the table above suggest, the price at the market will have to be settled somewhere between 7$/£ and 8$/£, as at the first of these, there would be shortage of pounds at the market and with the second one, there would already be a surplus of pounds25. We could also put the whole framework into a graphical form as it was in our previous investigations – with Mr. Smith’s declining demand curve and Mr. Brown’s increasing supply curve. We could clearly observe potential shortage and potential surplus for the prices below and above the crossing of the two lines that connect respective supplied and demanded quantities.
25 The Austrian price theory discusses delineation of pricing boundaries into more detail, however, as this set of problems is not of a direct interest of this study, we will leave the topic here with references to the relevant literature: Böhm-Bawerk (1959, pp. 215 ff.), Mises (1971, p. 108), Menger (1994, pp. 175 ff.)
0 2 4 6 8 10 12
0 1 2 3 4 5 6 7
Quantity of pounds (units)
Price ($/£)
Figure 14: Mr. Brown and Mr. Smith: individual supply and individual demand
As changes in valuations do tend to change supply and demand schedules, changes in these valuations also do have the ability to change the exchange rate – to make it higher or lower than it otherwise would have been. It is clear that not all changes in valuation necessary lead to changes in exchange rate, as these changed valuations could also affect only supplied and demanded quantities for potential prices that are not applicable at the moment (in our example, it could be quantities for the price of 100$/£ that probably would not be applicable).
On the other hand, if the valuation changes supplied or demanded quantities for the relevant sections of the supply and demand schedules, exchange rate is affected. Increase or decrease in relative importance of dollar-ends in respect with pound-ends in the eyes of demander of pounds brings the exchange rate higher or lower than otherwise respectively. On the other hand, increase or decrease in relative importance of dollar-ends in respect with pound-ends in the eyes of supplier of pounds brings the exchange rate lower or higher than otherwise respectively.
2.1.5.5 Foreign exchange market of a multiple of individuals
Aggregated supply schedule and demand schedule of the foreign exchange market do not bring much of a difference to the analysis when compared with the previous case of individual schedules. As it springs from the logic of action that individual’s quantity demanded always increases or is stable with price decreasing and as it is also the case that individual’s quantity
supplied decreases or keeps constant with decreasing price, supply and demand curves remain increasing and decreasing respectively at the aggregated market as these represent just summation of respective individual supply and demand curves26. The only difference is in their exact shapes as valuations of individuals in respect with relative importance of dollar- ends (constituents of PDEE) and pound-ends (constituents of PFEE) might differ. An example of the aggregated foreign exchange market is portrayed in the figure below where aggregate preferences suggest that the price will be somewhere within the range of 6$/£ and 6.5$/£.
0 2 4 6 8 10 12
0 50 100 150 200 250 300
Quantity of pounds (billions)
Price ($/£)
Figure 15: Aggregated supply and aggregated demand at the foreign exchange market
Mechanism of changes in the exchange rate as a consequence of changes in valuations of individuals is the same on the aggregate basis as it is on the basis of two individuals:
aggregated demand for pounds and aggregated supply of pounds just represent potentially demanded and supplied quantities of individuals counted together, depending on the exchange rate in question. Change in the valuation of each individual thus affects the exchange rate on the basis of the same principle as it is in the case of individuals. We could now briefly discuss changes in aggregated valuations.
Let us start with the demand first. Decreased demand stands for the situation, when demanded quantity of pounds for given potential exchange rates decreases – viz. the leftward movement of the demand curve in the figure below. This results from lower relative valuation of ends
26 For general exposition cf. Rothbard (2004, pp. 233 ff.).
that could be obtained by pounds at these exchange rates; in our terminology, more dollars are to be spent for PDEE and less for PFEE. For the situations of decreased quantities demanded for potential exchange rates that are under given conditions viable also for suppliers of pounds, exchange rate declines, dollar appreciates. All this holds a vice versa for increased demand for pounds. Increased demand for pounds – viz. the rightwards movement of the demand curve in the figure below, correspondingly brings about depreciation of dollar – increase in the exchange rate.
0 2 4 6 8 10 12
0 50 100 150 200 250 300
Quantity of pounds (billions)
Price ($/£)
Figure 16: Changes in the demand for pounds
In respect with changes in the supply of pounds, i.e. changes in valuation of holders of pounds related with changes in relative valuation of foreign and domestic ends, the process is very similar as that with changes in demand. Increase in supply of pounds – relative increase in valuation of ends that are obtainable by dollars, causes appreciation of dollar (increase in the exchange rate). Decrease in the supply of pounds – relative decrease in valuation of ends that are obtainable by dollars, causes depreciation of dollar (decrease in the exchange rate). Both situations illustrate rightward and leftward movements of the picture below.
0 2 4 6 8 10 12
0 50 100 150 200 250 300
Quantity of pounds
Price ($/£)
Figure 17: Changes in the supply of pounds
2.2 Subjectivist theory and exchange rates: advanced considerations
The previous part was devoted to the creation of the general Austrian framework suitable for analysis of exchange rates. We based this framework directly on valuations of ends that are rooted behind decisions related with quantities supplied and demanded at the foreign exchange market. Present part, although built on the general concepts raised in the previous section, will focus to a rather different direction. The attention will be shifted from bare changes in one’s preferences, that are just given to economist, towards analysis of rather systematic influences exercised on these preferences. The crucial question naturally is, what these systematic influences are. In this respect, it should be stated clearly that there could hardly be any guarantee that some selected group of “systematic influences” is the final one;
each choice in this respect is to some extent arbitrary. Selection of the present part is based on the assessment of important phenomena that spring from the nature of the present analysis and analyses of important Austrian scholars. In this respect, our next steps will be the following:
First, the role of prices will be treated. Second, the role of price differentials will be discussed.
Third, subjectivist application of the Austrian approach to the purchasing power of money will be considered. Fourth, Austrian findings related with the non-neutrality of money will be combined with our exchange-rate considerations. And fifth, the Austrian exchange rate equilibrium condition will be criticized.
2.2.1 Valuation and Prices
One of the initial assumptions27 that delineates scope of our analysis states that money is a medium of exchange. As a consequence, and by the definition proposed here, it is a matter of fact that currency is obtained and held in order to be used for purchase of some economic good. To stress these important points in our context, let us turn back to the basic framework with a couple of amendments:
ER P
y money units (£)
zunits of good M
End F x money units
($)
Figure 18: Chain of individual’s actions: exchange rate and prices
The above scheme describes some important systematic factors that are relevant for the analysis of exchange rates (ER in the picture). These systematic factors include: valuation of the end (End F), foreign price (P) of the good leading to this end and the number of goods (z) purchased. We have already dealt to some extent with the impact of valuation of ends in respect with the exchange rate. The present section will be devoted, as it was already suggested, to the analysis of the influence of prices.
Keeping in line with the initial aim of our investigation – namely the search for the reasons of
“Why one exchanges certain amount of the domestic currency for another certain amount of the foreign currency?”, we are interested in understanding influences of prices on exchange rate. The natural question stands: In which possible ways could be change in a price of a good linked with the determination of the exchange rate?”
In order to treat the problem in a systematic way, we will discuss four following situations:
First, it will be the potential impact of the change in price of the foreign good on the respective demanded quantities of the foreign currency. Second, it will be the potential impact of the change in the price of the domestic good on the respective demanded quantities of the foreign currency. Third, it will be the potential impact of the change in price of the domestic good on the respective supplied quantities of the foreign currency. And fourth, it will be the potential impact of the change in price of the foreign good on the respective supplied quantities of the foreign currency.
27 Cf. section 2.1.2 of this work.
2.2.1.1 Individual prices of foreign goods and demand for the foreign currency
Let us assume that an individual is willing to attain some end that involves purchase of the foreign currency and buying z units of good at the price P. How much of the foreign currency does one have to buy in order to attain the end? The answer is clear: he needs P times z pounds, i.e., P*z £. Let us further assume that our individual is now just in the position of buying the amount of the currency at the foreign exchange market as he expects the price P and assumes the quantity z to lead to his highest Final End. However, the question is, in what way will be his decision affected with change in the expected price P. There is a multiple of options in respect with changes in the quantity of demanded pounds resulting from potential intended purchases of the good M. Their classification is provided in the table below28.
Change in the £ price of good M
Resulting
change in the quantity of M demanded (z)
Elasticity of demand for M
Change in the quantity of £ demanded for the sake of the purchase of M
increase decrease elastic decrease increase decrease /stable inelastic increase increase decrease unitary elastic stable decrease increase elastic increase decrease increase/stable inelastic decrease decrease increase unitary elastic stable
Table 5: Change the price of individual foreign good and changes in monetary outlays related with this good
It is clear that although the table is comprehensive in respect with the effects from the side of the good M, there are three important questions to be answered. First, what will be the overall effect on the individual quantity of pounds demanded at the exchange rate in question?
Second, what will be the overall effect in respect with all potential exchange rates, i.e., what will be the effect on the overall individual demand schedule for pounds? And third, what are the potential effects on the aggregated market demand schedule?
28 For the sake of simplicity that will be important namely for the analysis of the Table 6 below, we have omitted the option of change in the price while keeping the amount demanded or supplied stable as the category of its own. Results of this option for the quantities of pounds demanded are included to those related with inelastic demand for M, as the results in terms of quantities of pounds demanded are the same.
In respect with the first question, let us start back with the division of one’s Final Ends on the basis of the currency that was initially used for their attainment. We have thus domestic ends (PDEE) and foreign ends (PFEE), the later represented by purchases of M and those of other foreign goods29. With increase in price of the good M at the “given” (meaning assumed) exchange rate, our individual could for the same amount of dollars and the same amount of pounds, receive lower quantity of the good M. With the decrease in the price of M, for the same quantity of dollars and pounds, the individual could get higher quantity of the good M.
In both cases, the individual will again have to choose from potential bundles of PDEE and PFEE that would lead towards the most desirable attainable Final End. The question that is of particular interest in this respect is “What will be the (counterfactual) change in individual’s spending at the foreign exchange market?” In other words, whether higher or lower amount of pounds will be demanded at the exchange rate in question.
And the only answer for this question is that “It depends.” More precisely it depends on the complementarity and substitutability of goods leading towards other PFEE and PDEE in respect with the purchased quantity (and price) of good M. If goods leading towards other PFEE are important complements of M, than decreased quantity of M in one’s possession might lead to overall decrease in demand for other PFEE goods and also decrease in demand for pounds. On the other hand, if other PFEE goods are important substitutes to M, decrease in one’s demanded quantity of the later might bring about increased demand for the former and consequent increase in demanded quantity of pounds. Similar reasoning could be applied to the case of increased demanded quantity of M. To make apparent the fact that with, for example, increase in the price of M, the quantity of pounds demanded might increase as well as decrease, two examples will be provided.
First, we could imagine a situation of father Gepeto. Gepeto has 10$ at his disposal and is willing to purchase 2 pieces of wood for the foreign currency in order to warm himself for the winter. At the exchange rate of 2$/£, he expects the price of 2.5£/piece of wood.
Unfortunately for Gepeto, the price of wood increases in pounds to 4£/piece. As a consequence he is willing to buy only 1 piece of wood at the exchange rate in question. The rest of the money (2$) will be spent for purchase of apples sold for dollars. In other woods the
29 In the following text we will be referring to the non-M PFEE goods as to those „other PFEE“.
quantity of dollars for pounds declines as a consequence of change in price of the foreign good.
Second, let us take an example of Robin Hood. He could purchase grenades in the home country for 1$/piece and grenade launcher for 4 uses in the foreign country for 10£. The alternative is to buy arrows for his old bow at the price of 0.5£/piece. Under the presupposed exchange rate of 2$/£, and with monetary stock of 24$ Robin prefers having 4 grenades and 1 grenade launcher to 24 arrows, while these two options being the two most highly valued.
However, if we assume the price of the launcher to increase by 1£, Robin prefers the other alternative. In other words, his quantity demanded for the foreign currency increases with increase in the price of the foreign good.
Now, we could present systematic classification of possible situations that bring about different results for changes in the price of the foreign good. There are two important questions in this respect. The first one: are the goods purchased for the domestic currency rather substitutes or complements to the foreign good presently in question. And the second one: are the other goods purchased for the foreign currency rather substitutes or complements to the foreign good presently in question?
But first, it is important to state clearly what it means to be a substitute or a complement. If some good is a substitute to M, than with decrease in the amount of M demanded, related with increase in its price, the amount of this substitute increases. At the given price of the substitute, higher monetary outlays are related with the substitute than otherwise – (increased quantity timed the given price = increased spending for the good). Mutatis mutandis the same reasoning applies for the increase in the price of M with respective decrease in the amount of purchased substitutes. On the other hand, the amount of purchased M’s complements declines with decrease in the amount M demanded – result of the increased price of M. As a consequence, less money is spent for the complement altogether (lower quantity timed by the given price = decreased spending for the good).
There are no doubts that the actual situation might be a mixed one in respect with concrete goods representing PDEE and concrete goods representing other PFEE and their nature as substitutes or complements to M. In respect with the former group, some of the goods might be substitutes to the good in question (M) and others might stand for its complements. The
same could naturally hold at the same time for the goods representing the later group. As we are interested in the quantities demanded at the foreign exchange market, however, the important is the overall effect. In case that the total number of pounds demanded from the side of other goods purchased by the foreign currency is higher than it would have been otherwise, we will coin these goods together to be substitutes to the good in question, i.e. to good M in our case. In the opposite case we will call them complements.
Using a part of the previous table, we will now create a set of relevant options with respective consequences for the quantity demanded at the exchange rate in question. A couple of points should be stressed in the beginning, however. First, the amount of money in the hands of individual is given. Second, as we are investigating the situation for the concrete exchange rate, the exchange rate is “given” for the individual and consequently the increase in the amount of pounds demanded proportionally decreases the amount of dollars designated for domestic purchases and the other way round. Given all the potential possibilities of elasticity of demand of dollar holders for the good M as well as possibilities of complementarity and substitutability of other PFEE and PDEE in respect with good M, the summary table for potential consequences of changes in the price of M for the quantity of the foreign currency demanded is represented by the Table 6.
As one could see, changes in the quantities of currencies demanded are in bold letters. The lines that represent unthinkable states of affairs in gray. States of affairs that bring about increase in the quantity of pounds demanded are yellow, states of affairs that bring about decrease in the quantity of pounds demanded are red, and states of affairs that do not bring change in this respect are green.
Let us now take a look at the first line. Our individual faces increase in the price of the good M. We assume that his preferences in this situation – in contrast with the situation of the same exchange rate with the lower price of M – makes him use his money in a way that his total payments for good M decline. Moreover, as ends linked with use of M are also significantly linked with consumption of other foreign goods, our individual decreases purchases of these as well. Instead, he devotes more of his money for ends that are related with use of dollars in transactions outside of the market with the foreign exchange (those of PDEE). As a consequence, at the given exchange rate, our individual is willing to demand only lower amount of pounds.
