Relationship between prices and exchanges

The tables and charts published by Keynes in his Tract on Monetary Reform show a remarkable degree of sympathy between movements of exchanges and their purchasing power parities based on wholesale indexes. This led Keynes to the conclusion that 'purchasing power parity theory, even in its crude form, has worked passably well'. The figures and charts gave, however, no indication whatsoever about the nature of the causal relationship between the two curves. They simply supported the so-called 'equilibrium theory' under which there could be no lasting major discrepancies between price levels of various countries if trade between them was reasonably free and if exchanges were allowed to fluctuate freely.

In its original form Cassel's theory assumed unilateral effect of prices on exchanges without any reciprocity. During and immediately after the war Cassel expressed the view that even if exchanges deviated from their purchasing power parities sooner or later they were bound to return to them, implying that it was always exchange rates that adjusted themselves to price differentials. At the opposite extreme, a number of continental economists maintained, on the basis of the practical experience of their countries, that any substantial movement of exchange rates -whatever may be its cause -- strongly influenced price levels and therefore it affected purchasing power parities. Both extreme views were put forward with vigorous dogmatism and it took some time before a synthesis, in the form of the equilibrium theory according to which prices and exchanges tend to adjust themselves to each other and affect each other reciprocally, emerged from the controversy. Even when it did it attracted but little attention, because it was not nearly as striking as the extreme theories.

One of the compromise formulae that emerged from the controversy was that while, during relatively moderate stages of inflation, prices tended to influence exchanges rather than conversely, during advanced stages of inflation it was exchanges that largely determined prices. This conclusion was based on practical experience in Austria, Germany and other countries where during the runaway inflation of the early post-war period manufacturers and merchants acquired the habit of adjusting their prices every day, and indeed several times a day, to the latest exchange rates.

Another compromise formula put forward by a number of writers was that amidst conditions of advanced inflation prices and exchanges moved together simply because they were both influenced in the same sense by the material and psychological effects of inflation. In other words, prices and exchanges did not affect one another but were both affected by the excessive note issue.

Even though Cassel did refer casually to the possibility of prices being affected by exchanges in given circumstances his emphasis was so overwhelmingly on the side of the unilateral effect of prices on exchanges that his influence, and that of his school, on current opinion was entirely in that sense. The policy implications of this static theory, which disregarded the selfaggravating dynamism of the effect of exchanges on prices, will be discussed in detail in the next chapter, but it must be pointed out here that this one-sided theory misled a great many individuals between 1919 and 1922 into buying marks. The domestic purchasing power of the mark was obviously above its exchange value and it was, therefore, assumed that sooner or later its exchange value would adjust itself to its purchasing power parities by appreciating. Even after speculators ceased to believe that the mark would recover eventually to its pre-war parity, their new creed in purchasing power parities kept up their demand for mark notes.