This section is from the "Practical Banking" book, by Albert S. Bolles.
When a draft is offered for sale, how much will a bank pay for it? To answer this question clearly a brief explanation is necessary. If the business men in New York are selling about as many goods to the merchants in St. Louis as they, on the other hand, are selling to New Yorkers, then the bills of exchange drawn in both cities will be at par—in other words, they will be transferred from one person to another for just the amount expressed on their face. There may be a very slight difference, enough to pay the banks for the trouble of buying and selling them; but, for the moment, we will leave that fact out of sight. But now, suppose that the merchants of St. Louis are selling the New Yorkers three times as many goods as the former are buying in New York, then the merchants of New York would owe those of St. Louis three times as much money. The reader will perceive that there will be three times as many bills drawn by the merchants of St. Louis as by the New Yorkers, and if all the St. Louis merchants should wish to sell their bills they could not get par for them, because the buyers could not sell them at a profit, for the simple reason that there would be occasion for using only one-third of them in settling the debts due by the St. Louis merchants to the New Yorkers. On the other hand, if all the New Yorkers should desire to sell their bills they could get more than par for them, because the entire amount would settle only one-third of their indebtedness to the St. Louis merchants. The bills, therefore, which the New York merchants would draw on those in St. Louis would command a premium, while the bills drawn by the St. Louis merchants on the New York ones would be at a discount. It may be added here, in passing, that the bills drawn by the New York merchants on those in St Louis would be called St. Louis exchange, and the bills drawn by the St. Louis merchants on those in New York, New York exchange. When the New York merchants cannot get St. Louis exchange at par, but must pay a premium therefor, the rate of exchange as between the two cities is said to be against New York; if the St. Louis merchants should owe a balance to those in New York, then they would be obliged to pay a premium to get New York exchange with which to settle their indebtedness, and the rate of exchange would be in favor of New York. In other words, the rate of exchange is always against the place that owes the most money, and in favor of the place that owes the least. But the rate of exchange does not exceed the cost of transporting specie, and the cost of doing this between many places is small; for this reason the rate of exchange between Boston and New York is very little. Although a great many bills are drawn on these two cities, yet the rate is very low, because they are so near together, and the modes of communication are so perfect that money may be readily sent from one city to the other to discharge any indebtedness which may exist between them which cannot be easily settled with the medium of bills of exchange. Further on we have given quotations of bills of exchange drawn on New York by other places. It will be seen that the rate is only five cents on $ 1,000 in Boston —a sum too insignificant to be considered. But between New York and other places farther away the rate is higher.
One thing further ought to be said in this connection. At certain seasons of the year a large amount of grain is shipped from the West to the East, also pork, beef, lard, and other provisions; enormous quantities of cotton are shipped from the South, too, and many other articles which need not be mentioned. At the same time, Western merchants are making large purchases in the East, New York, Philadelphia, Boston, and elsewhere. But the purchases made in the East are not so heavy, as those made by the Eastern men of the West. The consequence is, there are not enough bills of exchange made in the East to pay all of the indebtedness to the West; in other words, the rate of exchange during those seasons of the year is pretty steadily against the Eastern cities. When the balance becomes large and the rate of exchange considerable, it is absolutely necessary to remit currency to the West to restore the balance of trade. There is no other way of restoring it. Years ago, when money was less plentiful in the West than it is at the present time, there was a more urgent need of transmitting money to effect these settlements. Even now, large quantities go at certain seasons of the year.
The banks buy bills of exchange in order to sell them again; this is a part of their regular business. They buy at one rate and sell at a higher rate. When the exchange is said to be at par between two cities it is not strictly so, inasmuch as a bank will not give quite as much for a bill of exchange as it asks for one when selling it. Of course, if it bought and sold at the same price no profit would be made in the business, and there would be no reason for undertaking it; hence, the buying and selling rate is never the same. Thus, in an ordinary newspaper report we find the following, which is extracted from the New York Journal of Commerce of August 1st:
The following are the rates of exchange on New York: Savannah, buying 1/8; selling 1/4% premium. Charleston, buying par@1/8 ; selling 3-16@1/4 premium. New Orleans commercial, $1.50 per $1,000 premium; bank, $2.50 per $1,000 premium.