The rate of exchange is the cost of paying foreign indebtedness per unit of money. Exchange between England and the United States is quoted in dollars and cents per pound sterling; exchange between France and England in francs per pound sterling, and exchange between France and the United States in francs per dollar. There is as much pure gold in one thousand English sovereigns, i.e. in one thousand pounds, as there is in four thousand eight hundred sixty-six dollars, approximately. In other words, the English sovereign is worth $4.866+. If a person living in New York had a debt of one thousand pounds sterling to pay in London, he might cancel the debt by sending $4866+ in American gold to London. Similarly, if a person living in London had to pay a debt of $4866+ in New York, he could satisfy the claim by sending one thousand pounds sterling to New York. But in either case it would cost twenty dollars or more to send the gold and it would certainly be wasteful to send gold in both directions at the same time. A much simpler way to settle the two accounts would be to cancel the indebtedness without shipping the gold. Thus A in New York owes a thousand pounds to B in London, and C in London owes a thousand pounds to D in New York. If by agreement, C pays a thousand pounds to B and A pays the equivalent of a thousand pounds in dollars to D, both debtors have discharged their indebtedness and both creditors are satisfied. Or D may make out an order in the form of a bill of exchange directing C to pay one thousand pounds to A. D sells this order to A and receives for it the equivalent in dollars of a thousand pounds. A indorses the order, making it payable to B and sends it to B. B presents it to C for payment and C pays a thousand pounds to B. In case there were as many A's and B's as there were C's and D's; that is, in case there was the same amount of indebtedness due from New York to London as from London to New York the equivalent of a thousand pounds in dollars would be $4866. The rate of exchange is 4.866, or, in other words, sterling exchange is at par.

1 In this book the distinction between foreign and domestic exchange is that in one case the drawer and drawee reside in different countries and in the other case they reside in the same country. According to another usage of terms foreign bills of exchange are drawn upon someone residing outside the state; domestic bills, upon someone residing within the state.

If, however, there are a great many more A's and B's than C's and D's; that is, if the payments to be made from New York to London greatly exceed those to be made from London to New York, some gold will have to be shipped from New York to London to settle the difference in the accounts. Since it ordinarily costs two cents a pound sterling or twenty dollars a thousand pounds to ship the gold, the A's who are unable to purchase orders from D's will be compelled to pay $4866 plus $20, or $4886, to cancel their obligations of a thousand pounds in London. Hence, the A's, in preference to paying for the shipment of gold, will compete with each other to secure the bills of exchange drawn by the D's upon the C's. This will drive the price of these bills of exchange above par. When the rate of exchange reaches 4.886; that is, when the price of D's order upon C for the payment of a thousand pounds has been bid up to $4886 by the A's, the competition will cease, since it would be cheaper to ship gold than to pay a higher price for the bill of exchange.

If, on the other hand, there are more C's and D's than A's and B's, the balance in gold will be shipped from London to New York. In that case it will cost D twenty dollars to bring the thousand pounds which was due him in London to New York. Rather than pay the twenty dollars for shipping the gold he will sell his bill of exchange for less than $4866. But he will not consent to sell it for less than $4846 because it would be more profitable to have the money paid to his account in London and shipped to New York than to sell the order at a rate below 4.846. The rates of exchange at which gold is shipped in either direction are called the gold points; that is, when the rate of exchange is 4.886, approximately, gold is shipped from New York to London and when the rate of exchange is 4.846 gold is shipped from London to New York.

While under ordinary conditions the rates of sterling exchange will not vary more than two cents above or below par, under the abnormal conditions prevailing in time of war a considerably greater deviation from par may be reached before gold is shipped. This is due to the fact that freight and insurance and interest charges have advanced and that the cost of shipping the gold has consequently been increased. In September, 1915, the rate of sterling exchange sank as low as 4.50 owing to our heavy exportations to Europe without corresponding importations before gold was imported and loans negotiated to relieve the situation.