Do prices affect exchanges directly

There was a fratricidal conflict amongst adherents of the purchasing power parity theory on the question whether purchasing power parities affected exchange rates directly or through their effect on the balance of payments. It was widely realised that if prices rose as a result of inflation this should tend to encourage imports and discourage exports. According to the extreme version of the purchasing power parity theory, however, the effect on exchanges was produced independently of the balance of payments. The exchange rate should depreciate to its new purchasing power parities even though exports and imports remained perfectly balanced, simply because those parities now constituted its new equilibrium level.

Cassel's formula implied that prices affected exchanges directly. His view that import and export restrictions were liable to affect the working of his theory, appeared to suggest, however, that purchasing power parities were only able to produce their effect on exchanges if they were allowed to produce their effect on the balance of payments. For this departure from the more dogmatic form of the doctrine he was taken severely to task by one of his extremist disciples, Miss van Dorp, who, writing in the Economic Journal, pointed out the contradiction that appeared to exist between Cassel's various writings on the subject. In face of this challenge Cassel reaffirmed his faith in the direct effect of purchasing power parities on exchanges, while upholding his admission about the possibility of their lasting deviations from those parities through trade restrictions.

HOW BALANCE OF PAYMENTS AFFECTS EXCHANGES

In his effort to discredit the balance of payments theory Cassel and his school went so far as to maintain that any surplus or deficit on the balance of payments could not affect the exchanges because it had to be paid somehow, even if it be through exporting securities or through raising credits. His conclusion was that the balance of payments must always balance by and large automatically and cannot therefore cause lasting changes in exchange rates. This argument was accepted uncritically during the early 'twenties by a remarkably large number of economists who appeared to be oblivious that it amounted to a repudiation of the entire classical theory of market mechanism.

In reality, while it is true that in all good markets supply and demand are always bound to balance each other automatically, what matters is that they balance each other largely through the effect of an imbalance on market prices. Any discrepancy between supply and demand of Foreign Exchange resulting from a surplus of imports or of exports is always balanced on a free market automatically, precisely through an adjustment of the exchange rate to a figure at which the required counterpart is forthcoming, through speculative or arbitrage operations or capital transfers. It was, therefore, utterly fallacious to argue that, because the balance of payments was always bound to balance, it could not affect exchange rates.