A Tract on Monetary Reform: Chapter IV - II. Stability of Prices versus Stability of Exchange

A Tract on Monetary Reform, by John Maynard Keynes is part of HackerNoon’s Book Blog Post series. You can jump to any chapter in this book here. Chapter IV: II. Stability of Prices versus Stability of Exchange.

II. Stability of Prices versus Stability of Exchange

Since, subject to the qualification of Chapter III., the rate of exchange of a country’s currency with the currency of the rest of the world (assuming for the sake of simplicity that there is only one external currency) depends on the relation between the internal price level and the external price level, it follows that the exchange cannot be stable unless both internal and external price levels remain stable. If, therefore, the external price level lies outside our control, we must submit either to our own internal price level or to our exchange being pulled about by external influences. If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.

In pre-war days, when almost the whole world was on a gold standard, we had all plumped for stability of exchange as against stability of prices, and we were ready to submit to the social consequences of a change of price level for causes quite outside our control, connected, for example, with the discovery of new gold mines in foreign countries or a change of banking policy abroad. But we submitted, partly because we did not dare trust ourselves to a less automatic (though more reasoned) policy, and partly because the price fluctuations experienced were in fact moderate. Nevertheless, there were powerful advocates of the other choice. In particular, the proposals of Professor Irving Fisher for a Compensated Dollar, amounted, unless all countries adopted the same plan, to putting into practice a preference for stability of internal price level over stability of external exchange.

The right choice is not necessarily the same for all countries. It must partly depend on the relative importance of foreign trade in the economic life of the country. Nevertheless, there does seem to be in almost every case a presumption in favour of the stability of prices, if only it can be achieved. Stability of exchange is in the nature of a convenience which adds to the efficiency and prosperity of those who are engaged in foreign trade. Stability of prices, on the other hand, is profoundly important for the avoidance of the various evils described in Chapter I. Contracts and business expectations, which presume a stable exchange, must be far fewer, even in a trading country such as England, than those which presume a stable level of internal prices. The main argument to the contrary seems to be that exchange stability is an easier aim to attain, since it only requires that the same standard of value should be adopted at home and abroad; whereas an internal standard, so regulated as to maintain stability in an index number of prices, is a difficult scientific innovation, never yet put into practice.

There has been an interesting example recently of a country which, more perhaps by chance than by design, has secured the advantages of a relatively stable level of internal prices at the expense of a fluctuating exchange, namely India. Public attention is so much fixed on the exchange as the test of the success of a financial policy, that the Government of India, under severe reproaches for what has happened, have not defended themselves as effectively as they might. During the boom of 1919–20, when world prices were soaring, the exchange value of the rupee was allowed to rise by successive stages, with the result that the highest level reached by the Indian index number in 1920 exceeded by only 12 per cent the average figure for 1919, whereas for England the figure was 29 per cent. The Report of the Indian Currency Committee, on which the Government of India acted somewhat clumsily without enough allowance for rapidly changing conditions, was avowedly influenced by the importance in such a country as India, especially in the political circumstances of that time, of avoiding a violent upward movement of internal prices. The most just criticism of the Government of India’s action, in the light of after-events, is that they went too far in attempting to raise the rupee so high as 2s. 8d.,—a rate not contemplated by the Currency Committee. Prices outside India never rose so high as to justify an exchange exceeding 2s. 3d. on the criterion of keeping Indian prices stable at the 1919 level. On the other hand, when world prices collapsed, the rupee exchange was allowed to fall with them, again with the result that the lowest point touched by the Indian index number in 1921 was only 16 per cent below the highest in 1920, whereas for England the figure was 50 per cent. The following table gives the details:

 Statist.

If the Government of India had been successful in stabilising the rupee-sterling exchange, they would necessarily have subjected India to a disastrous price fluctuation comparable to that in England. Thus the unthinking assumption, in favour of the restoration of a fixed exchange as the one thing to aim at, requires more examination than it sometimes receives.

Especially is this the case if the prospect that a majority of countries will adopt the same standard is still remote. When by adopting the gold standard we could achieve stability of exchange with almost the whole world, whilst any other standard would have appeared as a solitary eccentricity, the solid advantages of certainty and convenience supported the conservative preference for gold. Nevertheless, even so, the convenience of traders and the primitive passion for solid metal might not, I think, have been adequate to preserve the dynasty of gold, if it had not been for another, half-accidental circumstance; namely, that for many years past gold had afforded not only a stable exchange but, on the whole, a stable price level also. In fact, the choice between stable exchanges and stable prices had not presented itself as an acute dilemma. And when, prior to the development of the South African mines, we seemed to be faced with a continuously falling price level, the fierceness of the bimetallic controversy testified to the discontent provoked as soon as the existing standard appeared seriously incompatible with the stability of prices.

Indeed, it is doubtful whether the pre-war system for regulating the international flow of gold would have been capable of dealing with such large or sudden divergencies between the price levels of different countries as have occurred lately. The fault of the pre-war régime, under which the rates of exchange between a country and the outside world were fixed, and the internal price level had to adjust itself thereto (i.e. was chiefly governed by external influences), was that it was too slow and insensitive in its mode of operation. The fault of the post-war régime, under which the price level mainly depends on internal influences (i.e. internal currency and credit policy) and the rates of exchange with the outside world have to adjust themselves thereto, is that it is too rapid in its effect and over-sensitive, with the result that it may act violently for merely transitory causes. Nevertheless, when the fluctuations are large and sudden, a quick reaction is necessary for the maintenance of equilibrium; and the necessity for quick reaction has been one of the factors which have rendered the pre-war method inapplicable to post-war conditions, and have made every one nervous of proclaiming a final fixation of the exchange.

We are familiar with the causal chain along which the pre-war method reached its result. If gold flowed out of the country’s central reserves, this modified discount policy and the creation of credit, thus affecting the demand for, and hence the price of, the class of goods most sensitive to the ease of credit, and gradually, through the price of these goods, spreading its influence to the prices of goods generally, including those which enter into international trade, until at the new level of price foreign goods began to look dear at home and domestic goods cheap abroad, and the adverse balance was redressed. But this process might take months to work itself out. Nowadays, the gold reserves might be dangerously depleted before the compensating forces had time to operate. Moreover, the movement of the rate of interest up or down sometimes had more effect in attracting foreign capital or encouraging investment abroad than in influencing home prices. Where the disequilibrium was purely seasonal, this was an unqualified advantage; for it was much better that foreign funds should ebb and flow between the slack and the busy seasons than that prices should go up and down. But where it was due to more permanent causes, the adjustment even before the war might be imperfect; for the stimulus to foreign loans, whilst restoring the balance for the time being, might obscure the real seriousness of the situation, and enable a country to live beyond its resources for a considerable time at the risk of ultimate default.

Compare with this the instantaneous effects of the post-war method. If at the existing rate of exchange the amount of sterling offered in the exchange market during the course of the morning exceeds the amount of dollars offered, there is no gold available for export at a fixed price to bridge the gulf. Consequently the dollar rate of exchange must move until at the new rate the offerings of each of the two currencies in exchange for one another exactly balance in amount. But it is the inevitable result of this that within half an hour the relative prices of commodities entering into English-American trade, such as cotton and electrolytic copper, have adjusted themselves accordingly. Unless the American prices move to meet them half-way, the English prices immediately rise correspondent to the movement of the exchange.

This means that relative prices can be knocked about by the most fleeting influences of politics and of sentiment, and by the periodic pressure of seasonal trades. But it also means that the post-war method is a most rapid and powerful corrective of real disequilibria in the balance of international payments arising from whatever causes, and a wonderful preventive in the way of countries which are inclined to spend abroad beyond their resources.

Thus when there are violent shocks to the pre-existing equilibrium between the internal and external price-levels, the pre-war method is likely to break down in practice, simply because it cannot bring about the re-adjustment of internal prices quick enough. Theoretically, of course, the pre-war method must be able to make itself effective sooner or later, provided the movement of gold is allowed to continue without restriction, until the inflation or deflation of prices has taken place to the necessary extent. But in practice there is usually a limit to the rate and to the amount by which the actual currency or the metallic backing for it can be allowed to flow abroad. If the supply of money or credit is reduced faster than social and business arrangements allow prices to fall, intolerable inconveniences result. Perhaps some of the incidents of debasement of the coinage which are sprinkled through the currency history of the late Middle Ages were really due to a similar cause. Prior to the discovery of the New World the precious metals were, over a long period, becoming progressively scarcer in Europe through natural wastage in the absence of adequate new supplies, and the drain to the East; with the result that from time to time the price level in England (for example) would be established on too high a level in relation to European prices. The resulting tendency of silver to flow abroad, being accentuated perhaps by some special temporary cause, would give rise to complaints of a “scarcity of currency,” which really means an outflow of money faster than social organisation permits prices to fall. No doubt some of the debasements were helped by the fact that they profited incidentally a necessitous Exchequer. But they may have been, nevertheless,163 the best available expedient for meeting the currency problem. We shall look on Edward III.’s debasements of sterling money with a more tolerant eye if we regard them as a method of carrying into effect a preference for stability of internal prices over stability of external exchanges, celebrating that monarch as an enlightened forerunner of Professor Irving Fisher in advocacy of the “compensated dollar,” only more happy than the latter in his opportunities to carry theory into practice.

 Cf. Hawtrey, Currency and Credit, chap. xvii.

The reader should notice, further, the different parts played by discount policy under the one régime and under the other. With the pre-war method discount policy is a vital part of the process for restoring equilibrium between internal and external prices. With the post-war method it is not equally indispensable, since the fluctuation of the exchanges can bring about equilibrium without its aid;—though it remains, of course, as an instrument for influencing the internal price level and through this the exchanges, if we desire to establish either the one or the other at a different level from that which would have prevailed otherwise.

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Keynes, John Maynard. 2021. A Tract on Monetary Reform. Urbana, Illinois: Project Gutenberg. Retrieved May 2022 from 

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