Chapter III: The Theory of Money and of the Foreign Exchanges (3)

3. A failure to analyse the relation between spot and forward exchange may be, sometimes, partly responsible for a mistaken bank-rate policy. Dear money--that is to say, high interest rates for short-period loans--has two effects. The one is indirect and gradual--namely, in diminishing the volume of credit quoted by the banks. This effect is much the same now as it always was. It is desirable to produce it when prices are rising and business is trying to expand faster than the supply of real capital and effective demand can permit in the long run. It is undesirable when prices are falling and trade is depressed.

The other effect of dear money, or rather of dearer money in one centre than in another, used to be to draw gold from the cheaper centre for temporary employment in the dearer. But nowadays the only immediate effect is to cause a new adjustment of the difference between the spot and forward rates of exchange between the two centres. If money becomes dearer in London, the discount on forward dollars diminishes or gives way to a premium. The effect has been pointed out above of the relative cheapening of money in London in the latter half of 1922 in increasing the discount on forward dollars, and of the relative raising of money-rates in the middle of 1923 in diminishing the discount. Such are, in present circumstances, the principal direct consequences of a moderate difference between interest rates in the two centres, apart, of course, from the indirect, long-period influence. Since no one is likely to remit money temporarily from one money market to another on any important scale, with an uncovered exchange risk, merely to take advantage of ½ or 1 per cent per annum difference in the interest rate, the direct effect of dearer money on the _absolute_ level of the exchanges, as distinguished from the difference between spot and forward, is very small, being limited to the comparatively slight influence which the relation between spot and forward rates exerts on exchange speculators.[39] The pressure of arbitragers between spot and forward exchange, seeking to take advantage of the new situation, leads to a rapid adjustment of the difference between these rates, until the business of temporary remittance, as distinct from exchange speculation, is no more profitable than it was before, and consequently does not occur on any increased scale; with the result that there is no marked effect on the absolute level of the spot rate.

[39] If interest rates are raised in London, the discount on
forward dollars will decrease or a premium will appear.
This is likely to have some influence in encouraging
speculative sales of forward dollars (how much influence
depends on the proportion borne by the difference
between the spot and forward rates to the probable range
of fluctuation of the spot rate which the speculator
anticipates); and in so far as this is the case, the
covering sales of spot dollars by banks will move the rate
of exchange in favour of London.

The reasons given for the maintenance of a close relationship between the Bank of England’s rate and that of the American Federal Reserve Board sometimes show confusion. The eventual influence of an effective high bank-rate on the general situation is undisputed; but the belief that a moderate difference between bank-rates in London and New York reacts directly on the sterling-dollar exchange, as it used to do under a régime of convertibility, is a misapprehension. The direct reaction of this difference is on the discount for forward dollars as against spot dollars; and it cannot much affect the absolute level of the spot rate unless the change in relative money-rates is comparable in magnitude (as it used to be but no longer is) with the possible range of exchange fluctuations.