When sterling exchange; reaches either the gold exporting point or the gold importing point, certain forces, known as "correctives of the exchanges," come into operation to restore the international equilibrium. In the following explanation of the influences bearing upon the rise and fall of foreign exchange we shall for the sake of simplicity consider only the two great financial centers, London and New York. It should be borne in mind that when the rates of exchange on London are falling in New York, exchange on New York is rising in London and vice versa. The first corrective tending to bring down the price of exchange is the reduced demand for bills. When sterling rises to $4.89 or $4.90 bankers begin to buy gold and ship it abroad to create balances against which to draw and sell bills at these high rates. People who were in the market for bills now shift their demand to gold, thus lessening the demand for bills and tending to reduce the price. The second corrective is a lower level of prices resulting from the withdrawal of gold. The withdrawal of gold reduces the bank reserves and causes a curtailment of loans and credit. With the consequent slackening of business, commodity prices tend to fall and exports increase. The increase in exports gives rise to an increased supply of bills of exchange and a resulting decline in their price.
Another corrective of advancing foreign exchange when the price reaches the gold exporting point is the rise in the rate of interest. The curtailment of credit due to the withdrawal of funds from New York results in higher interest rates. A rising interest rate reduces the demand for exchange, first, because American bankers are instructed by their foreign correspondents to leave their funds in the New York market to take advantage of the high rates; and, second, because American banks will sell bills of exchange in order to secure funds to loan in this market. The action of these correctives will sooner or later bring about a fall in the price of exchange and the export of gold will be checked.
The correctives of falling exchange preventing a decline below the gold importing point operate in the same way. When sterling exchange falls to about $4.84 exporters instead of receiving their money by selling drafts on London have the gold shipped to them. This reduces the supply of bills and causes an increase in their price. In the second place, the importation of gold tends to raise the level of commodity prices, which results in increased imports and larger demand for exchange with which to pay for them. The increased demand for bills tends to raise their price. The third corrective is the interest rate, which operates in the same way as in rising exchange. When the interest rate in New York is low, it pays the banker better to buy bills of exchange than to loan in this market. Then again, instead of calling his funds home he will give instructions to have them loaned in the London or Paris market where the interest rate may be higher. These two factors, one decreasing the supply of bills and the other increasing the demand, will bring about a rise in the quotations for sterling, and after a time gold will tend to flow back again to this side While the foregoing explanation does not cover all the influences bearing upon the rise and fall of foreign exchange, it probably embraces the most important factors.1