Front Page Titles (by Subject) CHAPTER 4: FIDUCIARY MONEY, METAL AND PAPER - Economics, vol. 2: Modern Economic Problems
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CHAPTER 4: FIDUCIARY MONEY, METAL AND PAPER - Frank A. Fetter, Economics, vol. 2: Modern Economic Problems 
Economics, vol. 2: Modern Economic Problems, 2nd edition, revised (New York: The Century Co., 1923).
Part of: Economics, 2 vols.
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FIDUCIARY MONEY, METAL AND PAPER
§ 1. Character of fiduciary money. § 2. Present monetary system of the United States. § 3. Saturation point of fractional money. § 4. Light-weight fractional coins. § 5. Gresham’s law. § 6. Seigniorage on standard money. § 7. Fiduciary coinage on governmental account. § 8. Two stages of coinage debasement. § 9. The gold-exchange standard. § 10. Nature of governmental paper money. § 11. Irredeemable paper money in America. § 12. Irredeemable paper money in Europe. § 13. Theories of political money. § 14. Political money; theory and practice.
§ 1. Character of fiduciary money. The actual moneys in circulation in every modern country consist of a wide variety of pieces, differing in denomination, physical size, shape, and materials, mode of issue, source or authority of issue, and legal character. Among these kinds, one is usually the standard money and usually is a commodity. The exceptions indicated by the word “usually” are (a) that under the plan of bimetallism, two metals may be legally designated as the standard, making in fact an alternative standard, called, however, a double standard; and (b) that an irredeemable paper money may be, for the time, the standard money. The coinage of standard money often is free and gratuitous (or nearly so), and the value of the money is kept close to parity with its value as bullion by changing bullion into coin, or coin back into bullion, whenever there is an appreciable difference between the value in the two uses. This adjustment is brought about by the free action of the people. The government, having declared what is the standard money unit, and having provided a mint to make coins, leaves it to citizens, acting on the ordinary business motives, to decide when they will reduce or increase the number of coins in circulation.
The other kinds of money are not commodity money, and the materials of which they are made, whatever they may be, are not worth as much in any other uses as they are in their present monetary form. Their value is always referred to, and adjusted to, that of the commodity money, as long as any of it is in circulation. In contrast with commodity money, these other kinds may be called fiduciary money. By fiduciary money we mean money that has not a commodity value equal to its money value, but which is generally accepted because each receiver has faith that others in turn will take it in the same way. The faith (fides) is not always that the issuer of the money (whether it be a bank or the government) will redeem the money on demand at any future time; for fiduciary money may circulate while irredeemable, that is, either carrying no promise of redemption in the standard money or in fact not being redeemed. Yet often actual redemption on demand or a good prospect of future redemption is one of the circumstances stimulating the faith and the readiness of each person in turn to receive fiduciary money.
§ 2. Present monetary system of the United States. In the following table is given a summary of the main features marking the monetary system of the United States in 1920.
Not all this variety is essential to an efficient monetary system, and several of the kinds survive as the result of historical accidents (political and legislative). But all are now kept in accord with the value of the gold coin, which, it will be observed, is the only kind the amount of which is not artificially limited. Silver dollars are no longer coined, subsidiary silver and minor coins are issued only in exchange for other money, as are gold and silver certificates in exchange for gold or for silver, which they merely represent while in circulation.
§ 3. Saturation point of fractional money. Fiduciary money is that on which regularly the issuer makes a seigniorage charge.1 Let us consider now the effect of seigniorage on the value of money.
Fractional coins, called also subsidiary coins, are those of smaller denominations than the standard unit of money, as shillings and pence in England, and half dollars, quarter dollars, dimes, nickels, and cents in America. Money to serve well a variety of uses must be of different denominations, and “small change” is necessary to make small purchases and for exact settlement in larger payments that are not multiples of the standard unit. The amount required (or most convenient to use) in each denomination of fractional coins is thus a more or less certain portion of each person’s monetary demand, shaped by experience and fixed by habit. For example, within certain elastic limits of convenience quarters may be used for halves, and dimes for nickles (and vice versa); but each person has a point of preference. The total demand for each kind of change is the sum of the individual demands. This point where the amount of coins of any denomination (in relation to the whole monetary system) is most convenient may be called the saturation point of that kind of small change, up to which point the people prefer a share of their money in that form, and beyond which they will, if free to choose, exchange that kind for other denominations (smaller or larger). Each kind of money, as the cent, nickel, dime, has its own peculiar demand and its saturation point.
§ 4. Light-weight fractional coins. The standard metal is usually too valuable to be suitable for coins of the smaller denominations. Therefore, when gold is the standard, copper, nickel, and silver remain in use for small transactions. But if coins of these metals are issued at weights corresponding with their bullion value, difficulties often arise. Not only are they too heavy for convenience, but with every slight rise in their bullion value as compared with that of the standard metal, they become worth more as bullion than as coin and begin to disappear from circulation. This happened often throughout the Middle Ages and until the nineteenth century. The attempt was frequently made to coin gold and silver at a ratio of weight corresponding exactly to their market values at the time and, every time the market conditions varied, the best full-weight coins of one of the two metals were taken out of circulation; whereas the worn coins might remain in circulation.2 Business thus often suffered for lack of the proper proportion of the various denominations of coins. At length, to remedy this difficulty, fractional silver coins, often called “token coins,” were issued, in limited numbers, of less than full proportionate weight and bullion value, as compared with the standard commodity money.
This plan, having been partially tried, was generally adopted by the United States in 1853 at a time when the silver dollar of 371.25 fine grains was legally rated at the same value as the gold dollar of 23.22 grains, and was freely coined. The fractional coins were made a little more than six per cent lighter per dollar than the dollar coin; two half dollars or four quarters or ten dimes contained 93.52 cents’ worth of silver. Later silver bullion became worth much less in terms of gold, and for years the bullion value of the silver in a dollar of silver small change was between forty and sixty cents. Yet the fact that fractional coinage continued to circulate and exchange freely at parity with standard money showed that it had a monetary value equal to the standard money, dollar for dollar. Why was this?
The answer is, because it is artificially limited in quantity, so that it does not pass the point of saturation in the field of its use. Its value rests on its monetary use; it is fiduciary money, not commodity money. It is limited simply by letting “the needs of the people” determine its amount. This is done by issuing it only in exchange for other money of the larger denominations, and by redeeming it in other money on demand. Mostly, fractional coins are issued by the mints on the request of banks. One needing “change” gets it at the bank; when the bank finds its supply falling short it gets more in exchange for other forms of money, as shown in the table of the monetary system. As business increases in a period of prosperity, the demand for nickels, dimes, and quarters rises, and the mints work night and day to supply the need. If these coins were made in great quantities and forced into circulation by the government through paying them out to creditors and officials, their quantity would become excessive and they would fall in value (be at a discount) compared with standard money. But as this is not done, and as, moreover, they are redeemed on demand at the Treasury (and practically at every bank and post-office) in other money, any slight tendency to depreciation in any locality is at once corrected. The fractional coinage is maintained at a parity with the standard money in accordance with the monopoly principle, expressed in the limitation of the amount. The government makes a seigniorage profit on the fiduciary coinage, as shown in the appended table.3
§ 5. Gresham’s law. Coins may be light weight as the result of another cause—namely, the abrasion (wearing off) of the coins in circulation. Nearly always when this has occurred the worn coins have still been accepted as money, and ordinarily without any depreciation. It makes no difference what may be deemed the cause of their acceptance; whether it be habit, public opinion in business circles, or the act of law making them a legal tender; the essential thing is that they continue to be accepted as money. They have a value as money greater than the value of the bullion that is in them. Yet everybody takes them without hesitation as readily as if they were full weight. If, however, at this point, new full-weight coins are put into circulation, these at once disappear while the old worn coins remain in circulation—a fact that in medieval times was found both mystifying and annoying.
In explanation of this phenomenon was formulated Gresham’s law of the circulation side by side of coins of different bullion value: bad money drives out good money. Sir Thomas Gresham (whose name has but recently been given to this so-called law) explained the principle to Queen Elizabeth when counseling her regarding the recoinage of the debased money of the realm, as was done in 1560. He showed that when old worn coins were in circulation and the mint began putting out full-weight coins, the old lighter ones remained as money, while the new ones, being heavier, were picked out by jewelers and others needing to send money abroad.
Gresham’s law has a paradoxical wording and is frequently misunderstood. “Bad money,” as he used the term, meant, not counterfeit money, but merely worn coins that have a bullion value less than that of some other money then in circulation. But such “bad money” will not always drive out “good money.” The law applies only under certain conditions and within certain limitations. The “good” will be driven out only if the total amount of money in circulation is in excess of what would be needed if all were of full weight and of best quality. Paradoxically speaking, if there is not too much money altogether, the bad money is just as good as the good money. But, even if good money is driven out, it may not leave the country. It may be hoarded, or be picked out by banks and savings institutions to retain as their reserves, or be melted for use in the arts. Gresham’s “law” becomes thus a practical precept. As applied to the plan of recoinage it is: Withdraw worn coins as rapidly (in equal numbers) as you put new coins into circulation.
The continued circulation of “bad” money alongside of “good” money (light-weight alongside of full-weight coins), as long as the total number of coins is not in excess of the money demand for full-weight coins, is explained thus on exactly the same principle as is the circulation at parity of a light-weight fractional coinage, in the preceding section.
§ 6. Seigniorage on standard money. The fiduciary coinage problem presents itself under a somewhat different guise in case a seigniorage charge is made on all coinage, even of that metal used as the standard unit. In this case coinage might be free but not gratuitous. Then no bullion would be brought to the mint unless the coined pieces the owners received had a value equal to the bullion value plus the seigniorage charge. The power to impose a seigniorage charge is a monopoly power, a power of artificial limitation. The number of coins that can be issued without depreciation is limited to that number which would circulate if they were made full weight without a seigniorage charge. With this number of pieces, the money demand of the country is at the saturation point for full-weight metal coins. If more coins could in any way be put into circulation they would be worth less as money than as bullion, and would be melted or exported.
Assume that this full supply of gold money at the saturation point is 100,000 pieces or dollars; then consider the effect of imposing a seigniorage charge of 10 per cent on further coinage. If business or population did not increase, and until through loss, by fire and in other ways, and through use for industrial purposes, the quantity of money had been reduced below this point, the seigniorage charge would have no effect, and there would be no desire to change gold from bullion form into coin. But when any or all of these suggested changes take place, the value of the monetary unit relative to the bullion value will begin to rise. It will take on a monopoly value due to the limitation of coinage. When it has risen until the coin will buy any more than one ninth more bullion than was in it, the citizens will begin to take metal to the mint. After the 10 per cent charge is taken out they will receive a coin which, though containing one tenth less bullion, will be worth very nearly the same as the metal taken to the mint. No depreciation could take place unless the volume of business fell off so that less money was needed than before. In that case there would be no outlet for the excess of coins until they fell to their bullion value, i. e., till they lost the entire value of the seigniorage, the monopoly element in them. Melting or exporting them before that point was reached would cause to the owner the loss of whatever element of seigniorage value they contained.
We thus have arrived at the general principle of seigniorage: when coins are not issued beyond the saturation point, a seigniorage charge raises the monetary value of the money-material above its bullion, that is, its commodity, value. And this holds good of a large seigniorage charge as well as of a small one, even up to the extreme limit of a charge of 100 per cent. In this last case the government would retain the whole of the bullion brought to it and would give in return a piece of money made of material (metal or paper) with a negligible value.
§ 7. Fiduciary coinage on governmental account. The fiduciary coinage problem may be presented also when coinage is not free, and the times and amount of coinage are determined by law or by legally authorized officials. In this case the bullion must be obtained by purchase in the open market (and paid for by some form of legal money, or by bonds). Coinage is then said to be “on governmental account.”
Now, assuming that the normal money demand (the volume of business or sum of exchanges) remains unchanged, let us consider what will result if the government begins to issue money in this way when, as in the preceding case, 100,000 units of full-weight money are in circulation. This action might be taken most simply by recoining all the full-weight pieces that came into the treasury, making them contain one tenth less precious metal, and paying out 1111 pieces for every 1000 received. Every time this was done there would be an excess of 111 pieces above the normal money demand, and 111 full-weight pieces would be exported or melted (Gresham’s law). The process (in strict theory) may be repeated 90 times, at which point 90,000 full-weight coins have been received, 100,000 light-weight coins have been issued to take their place, and 10,000 full-weight coins have gone out of circulation. The total seigniorage profit would be one-tenth of 90,000, or 9,000 units of bullion. No depreciation has taken place,4 the pieces, by reason of their limitation, bear a money value in excess of the bullion that is in them.
Now the government, with the next 1000 pieces collected by taxation, could buy enough bullion (in the open market) to make another 1111. The excess of 111 pieces could not now be promptly removed by the melting down or exporting of 111 coins, for all those remaining in circulation have a bullion value one tenth below their money value. As this process is repeated the number of coins must continue to grow from 100,000 to 111,111, and the value of the money piece in terms of bullion continue to fall from ten to nine. At this point the 111,111 pieces would contain just the same amount of bullion and have just the same value as the 100,000 pieces did before. Thereafter no further profit would accrue to the government from issuing coins of that weight. To make a further profit it must again reduce the amount of pure metal in the coin.
§ 8. Two stages of coinage debasement. It will be seen that, taking the number of full-weight coins at the saturation point as parity (when price is 100), then (a) price rises directly as the number of units of money; (b) the value of the monetary unit is the reciprocal of price (changes inversely with the number of units of money).
When a new seigniorage charge is imposed, the change in the physical content of the coin is called debasement. Two stages of this change may be distinguished (as is shown in the preceding description). The first stage is debasement without depreciation of the monetary unit; the second stage is debasement with depreciation. In the first stage the monetary unit, as a result of limitation, has an artificial value in excess of its bullion value; in the second stage its monetary value falls toward its bullion value, but may (depending on limitation) rest anywhere between the former full-weight bullion value and the new bullion-content value.
The process illustrated above was often repeated in the Middle Ages. A ruler, either by making a higher seigniorage charge or by coining on his own account, debased the quality or reduced the weight of the money of his realm. For a time the new coins, having the same monetary use, circulated at par with the old coins. The ruler, pleased with this almost magical power of getting a revenue with little trouble, continued to issue coins, until suddenly the heavier coins began to be exported or melted, and the value of the other money fell, to the mystification alike of the prince and of his people. The reason is now perfectly plain: the number of coins was not kept within the proper limits and they went down to their bullion value. The only way a further profit could be made in this way was to debase the coin again. By successive steps the coinage came to consist almost entirely of cheaper alloy.
§ 9. The gold-exchange standard. In a number of silver-using countries and colonial dependencies near the end of the nineteenth century, the fluctuations of the value of silver in terms of gold was a constant source of difficulty in the payment of foreign obligations to gold standard countries. Yet there were strong reasons in the habits of the people and in the industrial conditions of the country to prevent the adoption of gold and the disuse of silver as the actual money in circulation. The method adopted, that of the gold-exchange standard, in operation in India since 1893, in the Philippines since 1903, and in Mexico since 1904, involves these features:
(1) Closing the mints of the country to the free coinage of silver.
(2) Adoption of a fixed ratio of exchange between the silver coins in circulation and a gold coin which is made the standard of value in all transactions (as the dollar or the pound sterling), the money in circulation thus being all or nearly all of a fiduciary nature.
(3) Regulation and limitation of the amount of silver money in circulation, so that a fixed parity between it and gold may be maintained, (a) by issuing coins in limited number and only on governmental account; (b) by the sale, at a fixed rate, of foreign exchange bills payable abroad in the standard unit, the money paid for the bills being withheld in a special reserve, thus reducing the total volume of money in circulation; (c) by the purchase of foreign bills of exchange at a fixed rate, thus paying out and putting again into circulation some of the fiduciary money in the special reserve.
These monetary changes furnish numerous illustrations and demonstrations of the quantity theory of money as applied to the entire circulating medium of the country.5 The silver coins which alone are in actual circulation become fiduciary by reason of the artificial limitation of their number, and their monetary value is made to conform to the value of gold6 as used in international trade.
§ 10. Nature of governmental paper money. The problem of seigniorage presents itself in its most extreme form when money is made of paper. Paper money is issued either by a government or by a bank. We will consider governmental notes here, reserving until later the case of bank notes.
The issue of paper money in some cases grew out of the practice of debasing metal. However this may have been, governmental paper money may be looked upon as money for which a seigniorage of 100 per cent is charged. The gain of seigniorage from paper money is greater and is just as easily secured as that from coinage of metals. Governmental paper money is called “political money,” in contrast to commodity money. However, all coins that contain an element of seigniorage, or monopoly value, are to that degree “political money.” The typical paper money is irredeemable; that is, it cannot be turned into bullion money on demand. It is simply put into circulation, usually with the “legal-tender” quality. Money has the legal tender quality (as the term is used in the United States) when, according to law, it must be accepted by citizens as a legal discharge for debts due them, unless otherwise provided in the contract. The prime purpose of making money legal tender is to reduce the danger of dispute as to payments; but another purpose often has been to force people to use a depreciated money whether they would or not. The purpose of the issue of political money is usually to gain the profit of seigniorage for the public treasury, and often it has been the desperate expedient of nearly bankrupt governments. Governmental paper money differs from bank-notes in that its value does not necessarily depend on the promise of redemption by the issuer. It differs from promissory notes and bonds in that its value is not based on the interest it yields, but mainly on its monetary uses. The issue of paper money may save the government the payment of interest on an equal amount of bonds. The promise to receive paper in payment for taxes or for public lands may help to maintain its value by reducing its quantity, but nothing short of its prompt redemption in standard coins makes it truly redeemable.
§ 11. Irredeemable paper money in America. The most notable examples of paper money in the eighteenth century were the American colonial currencies, the continental notes, and the French assignats. In all the American colonies before the Revolution, notes or bills of credit were issued which were in most cases legal tender. Parliament forbade the issues, but to no effect. Without exception they were issued in large amounts, and without exception they depreciated. The continental notes were issued by the Continental Congress in the first year of the war (1775), and for the next five years. The object at first was to anticipate taxes, and it was expected that the states would redeem and destroy the notes; but this was not done. The notes passed at par for a time, but depreciated rapidly as their number increased. It has been estimated that the country had less than $10,000,000 of coin before the war, and when, in 1780, more than $200,000,000 of notes were in circulation they were completely discredited: hence the phrase “not worth a continental.” Specie then quickly came back into use.
The United States, under the Constitution, did not try legal-tender paper money till 1862, when paper notes (called greenbacks, because of the color of ink with which the reverse side was printed) were first issued, later increased to a total of about $450,000,000. Other interest-bearing notes were issued with the legal-tender quality and circulated as money to some extent. Greenbacks depreciated in terms of gold, and gold rose in price in terms of greenbacks until, in June, 1864, it sold at 280 a hundred. Fourteen years elapsed after the war before these notes rose to par in terms of gold (in December, 1878), and they became legally redeemable in gold January 1, 1879. This was called the “resumption of specie payments.” Ever since that time the United States has maintained the gold standard.
§ 12. Irredeemable paper money in Europe. The leaders of the French Revolution, failing to learn the lesson of the American revolutionary experience, issued, on the security of land, notes called assignats in such enormous quantities that they became worth no more than the paper on which they were printed. The paper money issued by the Bank of England under the restriction act of 1797-1820 is especially notable because it gave rise to the controversy which did much to develop the modern theory of the subject. Parliament forbade the Bank of England to redeem its notes in coin because the government wished to borrow the coin the bank held. The result was the issue of a large amount of bank money not subject to the ordinary rule of redemption on demand. It was virtually governmental paper money. The notes depreciated and drove gold out of circulation, and it was not until 1821 that specie payments were definitely resumed. Essentially the method of the restriction act was applied by each of the belligerent nations to its state bank in the period of the World War.
Almost every nation has at some time issued political money. During the Franco-Prussian War in 1870, France, through the medium of its great state bank, made forced issues of notes of a political nature, which only slightly depreciated. Many countries—Russia, Austria, Portugal, Italy, and most of the South and Central American republics—have had or still have depreciated paper currencies.
At once, at the outbreak of the Great War in 1914, the governments of the warring nations began to exercise a strict control over the issue of paper money, sought in every way possible to gather into the public treasury all the precious metals in the form of coins or ornaments, and to give paper (either governmental notes or bank-notes) a forced circulation, making it the sole circulating medium. In such cases the money partakes somewhat of the characters both of bank-notes and of political money. Even in Great Britain the paper money (governmental and Bank of England notes) depreciated 20 per cent or more, compared with gold; in France and in Belgium, at the worst, nearly 60 per cent; whereas in many of the other continental countries (notably Germany and Austria) it fell nearly 99 per cent. In Russia the paper seems to have become quite worthless. The return to the gold standard is one of the most difficult tasks these countries have to perform.
§ 13. Theories of political money. There are two extreme views regarding the nature of paper money, and a third which endeavors to find the truth between these two. First is that of the cost-of-production theorists, who declare that government is powerless to influence value or to impart value to paper by law. They deny that there is any other basis for the value of money than the cost of the material that is in it. Money made of paper, on a printing-press, has a cost almost negligibly small, and therefore, they say, it can have no value. The facts that it does circulate and that it is treated as if it had value are explained by the cost-of-production theorists as follows: while the paper note is a mere promise to pay, with no value in itself, it is accepted because of the hope of its redemption, just as is any private note. Depreciation, according to this view, is due to loss of confidence; the rise toward par measures the hope of repayment.
Taking a very different view, the extreme fiat theorists assert that the government has unlimited power to maintain the value of paper money by conferring upon it the legal-tender quality. The meaning of fiat is “let there be,” and the fiat-money advocates believe that the government has but to say, “Let it be money” to impart value to a piece of paper. The typical fiat-money advocates in the United States were the “Greenbackers,” who wished to retain the greenbacks issued in the Civil War and to increase the amount greatly. They saw in paper money an unlimited source of income to the government. They proposed the payment of the national debt, the support of the government without taxes, and the loan of money without interest to citizens. All might live in luxury if the extreme fiat-money theorists could realize their dream. The depreciation that has taken place in nearly every case where government notes have been issued, the fiat theorists declare to be due to a mild enforcement of the law of legal tender. To them the fact that paper money may circulate for a time at par appears a reason why it always should. They do not recognize that there is a saturation point in the use of money.
The almost universally accepted opinion among economists rejects both of these views, while recognizing in each a certain limited aspect of the truth. The cost-of-production view overlooks the features in which paper money differs from ordinary credit paper. The value of a man’s promises to pay depends on his reputation and his resources; the resources constitute the basis of value. Bonds have value because they yield interest and are payable at a definite time in standard money. But paper money, lacking this basis for its value, has another basis in its money use, in its power to buy goods.
§ 14. Political money; theory and practice. The theory of paper money here outlined explains the value of paper money as a special case of political monopoly. As the power of any private monopoly over price is relative, not absolute, so is that of the government over the value of political money. The money use is the source of value of the paper notes. It is this that gives the economic condition for value in paper money and strictly limits the power of the government—a fact overlooked by the fiat theorists. Business conditions remaining unchanged, the limit of possible issue without depreciation is the number of units in circulation before the paper money was issued, the saturation point of full-weight and full-value coins. Under wise and honest control and regulation, political paper money might serve the monetary function very effectively. Since the end of the World War, from various quarters has been advanced the plan of an international paper money, to be issued by some organization like a world federal reserve bank. The amount and value of the notes would be regulated in conformity with the gold standard. To monetary students this plan is not new and is theoretically sound except for the political difficulties likely to arise.
Resorted to in desperate extremities, political money has usually proved to be a costly experiment. Once the issue of political money begins to be excessive, its further limitation proves to be most difficult. A result usually unintended is the derangement of business and of the existing distribution of incomes. The rapid and unpredictable changes in prices give opportunity for speculative profits, but injure legitimate business. This incidental effect on debts and industry offers the main motive to some citizens for advocating the issue of paper money. It is peculiarly liable to be the subject of political intrigue and of popular misunderstanding. It is this danger, more than anything else, that makes political money in general a poor kind of money.
[1 ]In the broad sense as before defined, ch. 3, § 1.
[2 ]See next section on worn coins in connection with Gresham’s law.
[3 ]Receipts and Expenditures of Mint Service in 1920.
[4 ]In this and following numerical examples no account is taken of the possibility that the standard metal may depreciate in the world market in terms of all other goods as a result of its diminished use as money in one or more countries. This properly belongs in a more complete theoretical treatment of the subject.
[5 ]See “Modern Currency Reforms” (1916), by E. W. Kemmerer, professor of Economics and Finance in Princeton University, for a detailed treatment of this remarkable series of monetary changes, probably unequaled in instructiveness to the student of monetary theory.
[6 ]That is, it is made to conform as closely as do the values of gold in two different countries, fluctuating within the upper and lower limits of the gold-shipping points, as explained more fully under international trade in ch. 15. § 10.