Mises went on to stress that the value of country’s currency is determined by the supply and demand of money so that “even the richest country can have a bad currency and the poorest country a good one”. (On the Manipulation of Money and Credit, Free Market Books, 1978. The article was first published in 1923). In other words monetary expansion is the fundamental cause of a falling exchange rate and not speculation or some mysterious link with another currency

The same phenomenon occurred in sixteenth and seventeenth century Spain when the country was bringing in massive amounts of gold and silver from its South American colonies. It was this unprecedented inflow of precious metals that triggered the “price revolution”. The results were predictable domestic prices rose relative to other countries causing the escudo to depreciate against their currencies.

In 1553 the Dominican Domingo de Soto, a Salamancan theologian and a prominent Spanish Scholastic, explained what was happening by applying supply-and-demand analysis to the problem. He concluded that

the more plentiful money is in Medina the more unfavourable are the terms of exchange and the higher the price must be paid by whoever wishes to send money from Spain to Flanders....And the scarcer the money is in Medina [i.e., the greater its purchasing power] the less he need pay there, because more people want money there than are sending it to Flanders.

What we have is an early application of the concept of purchasing power parity to explain exchange rates in terms of the relative purchasing power of other moneys. As von Mises put it: “Exchange rates are determined by the relative purchasing power per unit of each kind of money”.

This issue was resurrected in what is now called the “bullion debate” that occurred from 1800 to 1811. The debate was between two lines of thought: One had it that the cause of a falling exchange rate was an expanding money supply. This doctrine contained two clashing schools: one, led by the remarkable Peter Lord King, correctly had it that though “real factors” can cause the exchange rate to fluctuate money supply was the fundamental determining factor.

The clashing school, led by Ricardo, was mechanistic, insisted on proportionality and denied the existence of temporary factors. The anti-bullionist school, of which Thornton was a member, denied outright that money supply was the fundamental force at work.

In 1957 a study by Mr J. J. Polak, a Keynesian trained economist and an employee of the IMF, found that by implementing a policy of credit expansion a country would raise nominal incomes. In doing so, however, it would also generate a current account deficit. He concluded that increasing the money supply would change the demand for domestic and foreign goods, services and securities before any significant change in prices occurred.

His findings were in harmony with Peter Lord King’s own conclusions. In his classic Theory of International Trade (1933) Gottfried von Haberler stressed the very same point.

Looking at New Zealand we find that from March 1996 to January 2006 it expanded M1 by 111 per cent. For Australia it was 114 per cent. These are massive increases. We also see that for New Zealand M1 has been contracting since last October while it has been comparatively flat in Australia since last June.

I think we are in for some interesting times. Whatever the case, the economic commentariat needs to cleanup its act with respect to exchange rates and capital flows. Leaving out money supply is bound to result in confusing reports.

Gerard Jackson is Brookes’ economics editor

Subscribe to BrookesNews Bulletin