A resident of Chicago who owes a debt of one thousand dollars in New York might conceivably cancel the obligation by sending one thousand dollars in currency to his New York creditor. It is very improbable, however, that he will pursue this course. Instead he will probably go to his bank in Chicago which has a deposit in New York or which has a deposit with another bank which has a deposit in a New York bank, and purchase from this bank an order directing the New York bank to pay his creditor one thousand dollars. He pays his bank one thousand dollars plus the exchange and sends the draft to his creditor, who presents it at his bank in New York and receives credit for one thousand dollars. The creditor's bank sends it to the New York clearing house and it finally reaches the New York bank upon which it was drawn. As a result of the transaction the Chicago bank has decreased its New York deposit by one thousand dollars and has increased the money in its own vault by the same amount. If all payments were being made from Chicago to New York and none in the opposite direction, the Chicago banks would soon have depleted their New York deposits and would have a corresponding amount of money in Chicago. When this point was reached they could sell further drafts upon New York only through the process of establishing further credit there, as, for instance, by shipping currency from Chicago to New York. Under these circumstances purchasers of New York exchange in Chicago would have to pay for it not only its face value but also the cost of shipping currency from Chicago to New York. Thus, the man who owed a thousand dollars in New York might have to pay in Chicago a thousand dollars and forty or fifty cents to cancel the obligation. On the other hand, when there is a great excess of payments from New York to Chicago the deposits belonging to Chicago banks in the New York banks increase greatly and it becomes desirable to have currency shipped from New York to Chicago. At such times a Chicago bank which wishes to increase its New York deposits can often purchase from other Chicago banks drafts on New York on such terms that for less than a thousand dollars paid in Chicago it can secure the right to receive a thousand dollars in New York. In other words, under these conditions New York exchange in Chicago is at a discount. It must not be supposed that at one time New York money is more valuable and that at another time Chicago money is more valuable. In either case it is the United States money that is involved. It is not a problem of the value of money but of the cost of shipping money from one place to another. When the demand in Chicago for New York drafts greatly exceeds the supply, New York exchange in Chicago is at a premium. When the supply of New York drafts greatly exceeds the demand for them in Chicago, New York exchange is at a discount in Chicago. The matter is very simple when it is considered in terms of the burden of shipping money from one point to another. In the case of foreign exchange the problem appears to be complicated by reason of the fact that the money of two countries is involved. In principle, however, the problem will be found to be the same.

149. Foreign Bills Of Exchange

A draft is also known as a bill of exchange. It is an order by which the person who draws the instrument directs a second person (the drawee) to pay a sum of money to a third person (the payee). A foreignl bill of exchange differs from a domestic bill of exchange principally in that the drawee and the drawer usually live in different countries. There is no essential difference between the two forms. The student of foreign exchange is sometimes temporarily confused by the fact that different countries have different monetary systems, but the fluctuations in rates of exchange are not caused by this fact.