The Online Library of Liberty

A project of Liberty Fund, Inc.

• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

XII. Specie Movements and Velocity of Money

The classical economists were agreed that (abstracting from the process of distribution of newly-mined bullion) there were no specie movements under equilibrium conditions, and that specie moved only to restore and not to disturb equilibrium, or, as Ricardo put it, gold was “exported to find its level, not to destroy it.” 1 But on the range of circumstances which could disturb equilibrium in the balance of payments so as to require corrective specie movements they were, as we have seen, not in agreement. Wheatley, as much later Bastable and Nicholson, held that the balance of payments would adjust itself immediately, and without need of specie movements, to disturbances of a non-currency nature, through an immediate and presumably exactly equilibrating relative shift in the demand of the two regions for each other's commodities. Granted that a relative shift in demand as between the two countries may, without the aid of relative price changes, restore an equilibrium disturbed, say, by an international tribute, it is an error to suppose that the shift in demand can ordinarily occur, under the assumption, be it remembered, of a simple specie currency, without involving a prior or a supporting transfer of specie from the paying to the receiving country. The new equilibrium requires that more purchases measured in money be made per unit of time in the receiving country and less in the paying country; as has been shown above, it is by its effect on the relative monetary volume of purchases in the two countries that the relative shift in demands exercises its equilibrating influence. Unless as and because one country becomes obligated to make payments to the other velocity falls in the paying country and rises in the receiving country, these necessary relative changes in purchases and in demands will not occur except after and because of a relative change in the amount of specie in the two countries, and such changes in velocity are at least not certain to occur, nor to be in the right directions if they do occur. Acceptance of the doctrine that a relative shift in demand schedules may suffice, without changes in relative prices, to restore equilibrium in a disturbed international balance does not involve as a corollary that specie movements are unnecessary for restoration of equilibrium, as Wheatley, Bastable, Nicholson, and others seem to have supposed. The error arises from acceptance of a too simple version of the quantity theory of money, in which price levels and quantities of money must move together and in the same direction regardless of what variations may occur in other terms of the monetary equation. In its most extreme application this erroneous doctrine has led to the conclusion that if unilateral payments should perchance result in a relative shift in price levels in favor of the paying country, the movement of specie will be from the receiving to the paying country!2

It has been generally overlooked, however, that the velocity of money, or the ratio of the amount of purchases per unit of time to amount of money, has an important bearing on the extent of the specie movement which will be necessary to restore a disturbed equilibrium. It is not purchases, or transactions, in general which are significant for the mechanism of adjustment, but only purchases of certain kinds. If, for instance, a particular house has changed ownership as between dealers through purchase and sale three times in one year, and not at all in the next year, neither the transactions in one year nor their absence in the next year have any direct significance for the international mechanism. What matters is only the volume of expenditures which for the unit period operate to remove the purchased commodities from the market. Such purchases we will call final purchases, to distinguish them from transactions which do not consist of purchase and sale of commodities and services or which, if they do involve such purchase and sale, result merely in transfer of ownership from one person to another who will in turn before the unit period of time is over sell or be ready to sell the commodity or service, whether in the same form or not does not matter, to a third person. It is the relative change as between the two countries in the volume of final purchases, so defined, which plays a direct and equilibrating role in the mechanism of adjustment of international balances to disturbances.

Under the assumption of a simple specie currency, the significant velocity concept for the analysis of the mechanism of international trade is accordingly the ratio of final purchases per unit of time to the amount of specie in the country, which we will call the “final purchases velocity of money.” This concept is to be distinguished not only from the familiar velocity concept, or the “transactions velocity of money,” but also from the “income” or “circuit” velocity of money concept. This latter is for our purposes a more serviceable concept than the “transactions velocity,” since it disregards many kinds of transactions which are of no direct significance for the international mechanism. It is nevertheless not a wholly satisfactory concept for the present purpose. For any limited period of time “income” is not only difficult of measurement but almost incapable of definition. It does not matter, moreover, for the mechanism of international adjustment whether what is spent comes from current net income or from disposable capital funds, borrowings, internal or external, or “negative income” or business losses eventually to be defrayed by the creditors. Nor does it matter whether the expenditures are for consumption or for maintenance or expansion of investment, except indirectly as this may affect the productive resources of the country or the apportionment of expenditures as between different classes of commodities. What matters for present purposes is primarily the ratio to the volume of money of the expenditures per unit of time which, for that unit of time, make an equivalent reduction in the willingness to spend of the purchasers.3 The final purchases velocity of money will of course necessarily be much smaller than the transactions velocity. It may be smaller or larger than the income velocity. It will tend to be smaller than the income velocity in so far as the latter covers income not spent or invested at home but hoarded or lent abroad. It will tend to be larger than the income velocity in so far as the latter fails to take account of maintenance and replacement expenditures, disinvestment expenditures, or expenditures of the proceeds of external or internal borrowings.

Since the relative change in the amount of final purchases in the two areas is an important equilibrating factor in the process of adjustment to a disturbance in their international balances, then, assuming no change to occur in either country in the final purchases velocity of money, the greater is the weighted average final purchases velocity of money in the two countries combined, the smaller will be the amount of money necessary to be transferred to restore a disturbed equilibrium, other things remaining the same. If, as the result of a transfer of specie to meet the first instalments of new and periodic obligations of one country to the other, a sudden change occurs in the amount of money in each country, and the volume of final purchases in each country does not immediately respond proportionately to the change in the amount of money, the amount of transfer of money to the receiving country will for a time have to be greater than the amount of such transfer ultimately necessary, and after the velocities in the two countries have recovered their normal levels, but before the periodic payments have terminated, a partial return of money to the paying country will occur. If, on the other hand, change in the amount of money tends to be accompanied with change in its velocity in a corresponding direction, a smaller initial transfer of money will suffice for the time being, but as the velocities recede to their normal levels more money will have to be transferred from the paying to the receiving country to maintain their relative volumes of final purchases at the new equilibrium level. In all cases, the amount of specie transfer necessary for adjustment to a disturbance will depend on the velocities of money in the two areas as well as on the manner in which the demands for different classes of commodities behave as the amounts of money are varied. Except under very unusual conditions, however, adjustment of the balance of payments to new and continuing unilateral remittances will require some initial transfer of specie from the paying to the receiving country.

The final purchases velocities in the two countries not only help to determine the amount of specie transfer necessary for adjustment, but they also help to determine what effects the remittances shall have on the absolute price levels in the two countries combined. If in the receiving country money has a higher velocity than in the paying country, the transfer of means of payment will result in a higher level of prices for the two countries combined, and vice versa. It is even conceivable, though not of course probable, that reparations payments may result in higher (or in lower) prices in both of the countries. Failure to take into account the possibility of different velocities in the two countries has led some writers to deny this even as a theoretical possibility.4

The role of specie movements and of the velocity of money in the mechanism of adjustment to disturbances is illustrated in table V, in which it is assumed that before reparations the unweighted average ratio of expenditures on native to expenditures on foreign commodities for the two countries combined is unity, and that, in the absence of price changes, reparations payments will not disturb the proportions in which expenditures are distributed between native and foreign commodities in either country. Under these conditions reparations payments, as we have seen, would not disturb the terms of trade. The pre-reparations equilibrium is disturbed by the imposition on one of the countries of the obligation to pay reparations to the other for an indefinite period of time at the rate of 600 monetary units per month.

In case A, the final purchase velocity of money per month, both before and after5 the beginning of the reparations payments is unity in both countries, and prior to the transfer the final purchases per month are 3000 in the receiving country and 1500 in the paying country. There must therefore have been, in the initial equilibrium situation, 3000 monetary units in the former, and 1500 in the latter, country. A transfer of 600 monetary units from the paying to the receiving country takes place when the payments begin, and the resultant shifts in demands bring about an adjustment of the balance of payments of the two countries to the tribute without necessitating any change in prices. In case B the velocity of money per month both before and after the beginning of the tribute payments is 2 in the receiving country and 1 in the paying country, and prior to the transfer there are 1500 units of money in each of the countries. To restore equilibrium; a transfer of only 450 units of money is necessary. But since the transfer of money is from a low-velocity to a high-velocity country, it results in an increase in the world level of prices and of money incomes. As in case A, however, equilibrium is restored without any change in the terms of trade. In case C the velocity of money is ½ in the receiving country and 1 in the paying country, and prior to the transfer there are 6000 units of money in the receiving country and 1500 in the paying country. To restore equilibrium a transfer of 720 units of money is necessary. But since the transfer of money is from a high-velocity to a low-velocity country, it results in a decrease in the world level of prices and of money incomes. As in the previous cases, however, equilibrium is restored without any change in the terms of trade. Whatever other cases were chosen, the same conclusion would be indicated that the effect of a transfer of payments on relative prices is independent of the velocities, provided that such changes in money incomes as are offset by corresponding changes in prices are assumed not to affect the apportionment of expenditures among different classes of commodities.6

Solving for x, I_r and I_p

Allocation of I_r and I_p to the different classes of commodities in the proportions in which it is assumed each country would distribute its expenditures in the absence of relative price changes yields the remainder of the data necessary to determine whether relative changes in prices are necessary for the new equilibrium, and, if so, in what direction.

In the older literature, analysis of this sort of the role of velocity of money in the mechanism of adjustment of international balances is to be found, if at all, only by implication. In the more recent literature, also, discussion of this phase of the mechanism is scanty. Ohlin's treatment of velocity is imbedded in his exposition of the mechanism as a whole, but there seems to me to be agreement between our accounts in so far as they cover the same ground. D. H. Robertson, in a short essay,7 which nevertheless contains in germ much of what has here been more elaborately expounded with reference to the transfer mechanism, also treats the velocity factor, in so far as he carries his analysis, in the same manner in which it is here treated. But concerned presumably more with establishing certain possibilities than with surveying the range of probabilities, he applies his analysis only to assumptions so extreme as to lead him to highly improbable conclusions. In an analysis of the effects of reparations payments by Germany to America on specie movements, terms of trade, and aggregate income in the two countries, he introduces an annual velocity of money factor, assumed to be unity and invariable in each country, and which represents the ratio of annual income, or annual expenditure, to the stock of money. From an arithmetical illustration he concludes that the payment by Germany of reparations need involve no transfer of money, no alteration in the terms of trade, and no change in “gross monetary income” in either country. Substituting “final purchases” for “gross monetary income,” and taking only the data which he presents for America, his illustration is as follows:

America

Before Reparations Payments

Final purchases of £1,600 buy 900 American goods + 100 German goods and pay £600 taxes.

Gold stock £1,600. V = 1.

Price of American goods = £1.

During Reparations Payments at the rate of £600 per year

Final purchases of £1,600 buy 900 American goods + 700 German goods.

Gold stock £1,600. V = 1.

Price of American goods = £1.

How extreme the assumptions are on which all of these results depend is not made apparent only because they are not brought clearly into the open in either the illustration or the accompanying text. The illustration assumes that the government of America uses the proceeds of the reparations payments to remit taxation, but it presumably continues to render the same services to the community, for otherwise £600 of spending power would be unaccounted for. As far as final purchases or “gross money incomes” are concerned, the apparent absence of an increase when reparations are received is due solely to the fact that real income in the form of government services for which previously £600 was paid by individuals in taxes is now met by the reparations income of the government and therefore does not appear in the accounts of private monetary income. As far as money stocks are concerned, the absence of any increase in the receiving country can be explained only if the periodic receipt of the reparations payments and their use by the government in hiring personnel and buying materials with which to carry out its functions requires no use of the country's stock of money, whereas collection of taxes equal in amount to the reparations plus use of the tax receipts in the identical fashion in which the proceeds of the reparations are used would involve the use of £600 throughout the year. As far as the commodity terms of trade are concerned, the absence of any change is to be explained by the assumption that although in the receiving country no prices have changed and spending power has increased by £600, no increase will occur in that country in the amount of its own goods or governmental services demanded by its people.

[1]High price of bullion, appendix, Works, p. 293.

[2]Such doctrine has actually been applied by Pigou, by Haberler, and by others following them, to the reparations transfer problem. In Pigou's analysis there is failure to notice that even if prices rise in Germany and fall in England as the result of reparations payments by Germany to England, there must nevertheless be a reduction in Germany and an increase in England in the relative amount of money income available for final expenditure and therefore in the amount of money work to be done. (Pigou, “The effect of reparations on the ratio of international exchange,” Economic journal, XLII (1932), 542-43.) Haberler seems to reach his conclusion that if reparations result in a relative rise in prices in the paying country the movement of specie will be to instead of from the paying country on the basis of a tacit assumption that price level and quantity of money must vary in the same direction regardless of other circumstances. In his treatment of the reparations transfer problem, Haberler writes: It is theoretically possible for the terms of trade to change in favor of Germany so that the prices of German exports rise and the prices of German imports fall. This leads to the rather paradoxical result that gold flows into Germany, and the transfer mechanism thus cases the situation of the country paying reparations. This is not a very probable case, but it would arise if the increase of foreign demand were for German exports, and the fall in Germany's demand related to imports. (Theory of international trade, 1936, pp. 75-76.)

[3]An essentially similar concept is used for the same purposes by Ohlin (Interregional and international trade, 1933, pp. 378, 407, note).

[4]Cf. Rueff's “principle of the conservation of purchasing power,” according to which the transfer of a given amount of “purchasing power” (i.e., specie?) between two countries cannot result in a change in the aggregate power to purchase, measured in money, of the two countries.—Jacques Rueff, “Mr. Keynes' views on the transfer problem,” Economic journal, XXXIX (1929), 388-99.

[5]Theoretically, other things being equal, and especially the “transactions velocity” of money remaining constant in each country, the final purchase velocity of money should be expected to fall slightly in the paying country and to rise slightly in the receiving country as the result of reparations, since in the paying country there will be production involving the use of money but not resulting in “final purchases,” and in the receiving country there will be final purchases not involving, directly or indirectly, domestic production, and therefore absorbing less than the normal amount of means of payment for their mediation.

[6]The results presented in these cases are not arbitrary, nor merely possible, but follow necessarily from the assumptions explicitly made in connection therewith. In case C, for example, the results as to the apportionment of expenditures and the distribution of money between the two countries after adjustment has been made to the payments are obtained as follows. Write:

ir for the amount available for expenditure in the receiving country before transfer (=3000). ip for the amount available for expenditure in the paying country before transfer (=1500). Ir for the amount available for expenditure in the receiving country after transfer. Ip for the amount available for expenditure in the paying country after transfer. x for the ratio of the weighted average velocity after transfer to the weighted average velocity before transfer, for the two countries combined. Then

[7]“The transfer problem,” in Pigou and Robertson, Economic essays and addresses, 1931, pp. 170-81.