Fritz Machlup, The Theory of Foreign Exchanges, Part I (1939)

Fritz Machlup’s journal article, the first installment of a projected treatment of foreign-exchange theory, reconnects international monetary analysis with the tools of value theory. Its three sections establish a simplified exchange market, derive exchange-demand and exchange-supply elasticities from commodity markets, and introduce capital movements, unilateral payments, and services. Gold flows, stabilisation arrangements, and speculative activities belong to the announced continuation. The central argument is that exchange rates emerge from interdependent market conditions, not from commodity prices or national price levels treated as independently given.

Machlup begins by combining domestic and foreign, spot and forward exchange markets into one perfect market, with one currency functioning as the commodity and the other as money. Initially, commodity exports alone supply foreign exchange and imports alone demand it; lending, accumulated balances, gold movements, and other payments are excluded. Consequently, exports and imports must balance even over the shortest interval. This is an implication of the assumptions, not a general assertion about actual trade. Timing refers to orders and their accompanying exchange transactions rather than goods crossing frontiers.

The distinction between adjustment periods then qualifies the graphical framework. Instantaneous supply may be inelastic, but exporters can respond rapidly to exchange-rate changes. Short-period analysis allows commodity prices and quantities to adjust while tastes and productive equipment remain given; long-period analysis additionally permits plant expansion. The relevant curves therefore incorporate commodity-market responses rather than assuming fixed commodity prices.

The study of the elasticities of supply and demand is, thus, the core of the theory of foreign exchange rates.

Section II makes this proposition concrete by tracing exchange elasticities through production, consumption, and competition in both countries. Exporters’ supply of foreign exchange depends on foreign demand for their goods, the responsiveness of competing foreign producers, domestic production capacity, and domestic consumers’ willingness to relinquish exportable goods as prices rise. Exhausted quotas can prevent expansion; specific duties and foreign distribution costs weaken the effect of exchange-rate changes on final prices.

A crucial distinction separates demand for an article from demand for a particular country’s exports. Even where aggregate consumption responds little to cheaper prices, exporters may gain substantial business from foreign competitors. Exchange-rate changes may also make previously unexported goods exportable, so estimates based exclusively on existing trade omit a potentially important response. Nevertheless, Machlup allows a backward-bending exchange-supply curve: export quantities may rise while receipts in foreign currency fall. Dollar receipts can rise simultaneously, making the currency of measurement analytically decisive.

Import demand has corresponding determinants: domestic consumption, competing domestic production, foreign productive capacity, and foreign consumers’ willingness to release goods. Yet the apparent symmetry has limits. Competition among sellers can make demand facing an individual exporter highly elastic without making aggregate demand in an importing country equally elastic. Potential new imports matter, but theory alone cannot establish whether total import demand exceeds unit elasticity.

Section III adds non-trade demands for exchange. A payment fixed in domestic currency produces unit-elastic exchange demand; an unavoidable obligation fixed in foreign currency produces perfectly inelastic demand. Foreign investment responds more flexibly. Provisionally holding commodity schedules unchanged, capital export raises the exchange rate, expands export receipts, and reduces import expenditure measured in foreign currency. Domestic-currency import expenditure may instead increase.

Statisticians, trying to "verify" a fall in imports due to increased capital exports, should beware of this trap.

The warning links theoretical precision to empirical interpretation: nominal trade values cannot be compared without specifying their currency. Under the restricted assumptions, net capital exports equal the commodity export surplus. Travel, remittances, investment income, and shipping services can likewise be incorporated into aggregate exchange schedules, although their elasticities and relationships with merchandise trade differ.

Machlup next removes the provisional assumption that commodity schedules remain unchanged. Spending abroad displaces other expenditures, while the domestic money paid for foreign exchange reaches exporters. These reallocations can shift both import demand and export supply; they must be distinguished from movements along unchanged curves.

Thus, an increased demand for foreign exchange by tourists does not involve a withdrawal of purchasing power from circulation but merely a change of the flow of purchasing power through the national economic system.

With monetary circulation provisionally unchanged, this redistribution is distinct from the international transfer mechanisms associated with gold and short-term balances. Its effects cannot be determined in advance: incomes generated in expanding export industries may increase demand for imports rather than reduce it.

The conclusion offers a qualified assessment of purchasing-power parity. Inflation explains the enormous depreciations of the early 1920s, and Machlup credits parity theory for identifying their monetary cause. But this historical success does not establish price levels as autonomous determinants of every exchange-rate movement.

And we saw that without "inflation" or "deflation" in any of the countries concerned, the exchange rates between them could be changed through a number of events.

Changes in tastes, productivity, and international payments can alter exchange rates without preceding monetary expansion or contraction. The installment’s enduring analytical contribution is to connect these changes to underlying commodity-market schedules while distinguishing accounting identities, currency valuation, and behavioural adjustment.