gold reserves, and her trade balance by gold movements. Because she was always in a position to take this step if necessary, it was never noticed that she did not take it, and consequently New Zealand was credited with a gold standard whereas in reality she had evolved a system in every way superior for her purpose, the system of an exchange standard, backed by currency largely composed of gold.

The essence of an exchange standard consists of the maintenance of an approximately fixed exchange rate, and the automatic increase or decrease of monetary media within the exchange standard country to the extent of the net balance of its payments through the exchanges. Like every other method of monetary regulation this plan postulates the Quantity Theory, and depends for its effect on influencing the amount of monetary media available. Variations in this amount react upon the volume of business, and through business, upon the trade balance, which in turn exerts the chief control over the exchange rates. Hence there is a marked degree of mutual dependence between the amount of a country's money and its rates of exchange. This mutual dependence is recognised in the theory of purchasing power parity, which states that the exchange rate tends to settle at a point where it registers the relative values, measured in transportable goods, of the monetary units exchanged. The universal validity of this theory, as a general proposition, must be admitted, for normally any departure from the purchasing power parity immediately sets forces moving that tend to correct it. It follows that if conditions are to be imposed which will maintain permanently a stable exchange rate, such conditions must provide for the maintenance of the normal ratio between the values of the monetary units to be exchanged, that is, they must ensure the automatic correction of deviations from that normal ratio. Under free gold standards this correction was provided by the movement of gold, or by the measures taken to prevent gold movement. In either case the effect was achieved by regulating the quantity of money available. Under an exchange standard the effect is attained in the same way. For the necessary correction is ensured by providing that the money of the exchange country shall expand or contract automatically with similar changes in central reserves held overseas, variations in both being governed by the net balance of international payments. A favourable balance, indicating that the value of the dependent monetary unit is higher than that expressed in the ratio registered by the exchange rate, automatically expands the

monetary media by the net amount of the favourable balance, and so tends to lower the value of each unit to that expressed in the normal ratio. On the other hand, an unfavourable balance, indicating a monetary value lower than that registered by the exchange, contracts the monetary supply by the net amount of the unfavourable balance, and, by raising the value of the unit, tends again to restore the ratio.

1

In these essential features the New Zealand system is similar to that of the Gold Exchange Standard countries. But, taking India as an example of this standard, New Zealand differs in one important particular. India is chiefly a currency-using country, and monetary regulation consists in expanding or contracting currency to the extent of the net balance of international payments. In New Zealand banking is highly developed, and the exchange standard is operated entirely through credit, that is, by the automatic expansion and contraction of bank deposits to the extent of the net balance of international payments. But just as" the stability of the Indian system depends upon their keeping sufficient reserves of coined rupees to enable them at all times to exchange international currency for local currency, and sufficient liquid reserves in sterling to enable them to change back the local currency into international currency, whenever they are required to do so," 1 so the stability of the New Zealand system depends upon bankers having sufficient liberty of credit expansion in New Zealand to enable them at all times to provide bank deposits in New Zealand in exchange for international money, and sufficient liquid resources in sterling to enable them at all times to provide international money in exchange for bank deposits in New Zealand. Normally both these conditions are maintained. The practical freedom of note issue releases bankers from the operation of the usual check upon credit expansion, and the reserves in London are usually sufficient for all demands likely to be made on them. But if either of these conditions fails to be maintained the system may break down. Thus in 1921, owing to an extraordinary excess of imports, bankers' exchange reserves in London were practically exhausted. The cable transfer rate on London rose to 3 per cent. premium, and exchange was rationed. The fact that rationing was resorted to in preference to a higher exchange rate shows how deeply the approximate par rate has become rooted in the mind of the banking and commercial world. But this movement, the most violent on record, and wider, it is hoped, than any likely 1 Keynes, Indian Currency and Finance, p. 10.

to occur in the future, was hardly sufficient to be termed more than a temporary impairment of the system. The normal working has since been restored and the rate has become slightly favourable. With a practically free note issue a breakdown owing to the failure of the other condition is unlikely to occur in New Zealand.

IV. The Position in Australia

But in Australia the note issue is not free, and for that very reason the working of the exchange mechanism has partly broken down. There the monetary situation is at present causing grave concern to bankers and traders alike. A marked monetary stringency has developed in Australia, while the Australian banks have a surplus of funds in London which they are unable satisfactorily to transfer. Consequently exporters are experiencing difficulty and loss in realising in Australia funds paid to them in London. Bankers who normally transfer these funds complain that they cannot do so on account of the shortage of notes, and demand that more notes be issued. The Note Issue Board of the Commonwealth, which controls the issue of notes, holds firmly " that there are at present sufficient notes in circulation, and that any further issues must increase the inflation which they consider already exists and cause a rise in the cost of living. The Board is very firm on this point, for it is understood that it refused the request of four banks to issue notes in exchange for gold, even though the amount involved was not large, and the issue was to be a temporary one." 1 The facts of the monetary situation are illustrated in the following table :

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This table supports the contention that a shortage of currency exists, for it shows a marked disproportion between the changes in bank deposits and in cash reserves since 1914. From June 1914 to December 1923 deposits increased by 88 per cent., whereas notes and gold increased by only 22 per cent. But since gold no longer circulates the effective reserve against demand liabilities is limited to notes, and on the basis of notes and gold in 1914, and notes alone in 1923, cash reserves have decreased by 30 per cent. Moreover, since 1919 deposits have increased by 23 per cent., while note reserves have decreased by 22 per cent. In Australia, as elsewhere, a fairly constant proportion, dependent on the habits of the public, is maintained between the amounts of cash and credit media in use, and hence a restriction of currency must sooner or later be reflected in a limitation of credit. If it is true that the Note Issue Board refuses to issue further notes even against gold, then, since gold does not circulate, the effective cash reserves of the banks at the end of 1923 were only £28 m., and of this a large proportion, stated to amount to over £20 m., consisted of £1000 notes, which are not issued to the public, but are used only for payments between the banks.1 This leaves less than £8 m. as the banks' holdings of cash for circulation against £300 m. of deposits, of which more than half are payable on demand. Under such conditions elasticity of credit is manifestly impossible.

It has been shown in the case of New Zealand that stability of the exchange rate depends on the maintenance of two essential conditions, a London reserve sufficient to enable bankers to provide sterling at all times in exchange for domestic deposits, and sufficient liberty of credit expansion to enable bankers at all times to provide domestic deposits in exchange for sterling. Herein lies the crux of the Australian difficulty, for Australia's exchange methods are precisely similar in all respects to those of New Zealand. Like New Zealanders, Australians "transfer " money to or from London through their bankers, who accept cheques or cash in Australia in return for claims on the banks' London reserves, and who receive money in London in exchange for cash or credits, but mostly credits, which they provide in Australia. As in the case of New Zealand, a favourable balance of payments increases both London reserves and the excess of deposits over advances in Australia, while an unfavourable balance has the opposite effect. Reference to the above table will show how changes in the excess of deposits over advances 1 Australian Investment Digest, July 1, 1924, p. 296.

have occurred in recent years, and though the corresponding figures for London reserves are not available, it is well known that they fluctuate considerably, and the explanation of their movements given here is manifestly the correct one. For Australia, as for New Zealand, this exchange system gradually developed during pre-war years. Though gold was produced and coined at three branches of the Royal Mint in Australia, bankers learned that their real reserves against international payments were needed, not in their home country, but in London. When gold payments and gold movements were suspended in 1914, this system of exchange was continued. During many stormy years it maintained a stable rate with London, the centre through which most of the trade is financed. In Australia its theoretical principles remained uninvestigated, unexplained, and unrecognised; but bankers became skilled in the practical details of its working, the trading public became accustomed to its use, and its chief manifestation, the par rate on London, became a rooted tradition in the commercial world. In 1921, when payment for an extraordinary import surplus had to be met, the London reserves became practically exhausted and the smooth working of the system was temporarily impaired. A recovery ensued, but now it has partially failed again. For, owing to shortage of cash reserves, the banks are unable to expand credit sufficiently to provide deposits in Australia in exchange for sterling in London.

Among the many suggested explanations of the exchange situation is one that it is the result of a change in the ratio of the value of the Australian pound to that of the sterling pound. Possibly this is so, but such a change must be essentially connected with monetary regulation in Australia, and this regulation may therefore be regarded as a primary cause. But the theory of purchasing power parity, which states that the exchange rate tends to register the ratio existing between the real values of the currencies concerned, measured in goods exchanged between them, assumes that other conditions, including costs of transferring the goods, remain unchanged. In the case of Australia, two important interferences with the normal ratio must be considered.

First, in 1921 the tariff was raised considerably. Consequently a wider margin is needed between British and Australian prices of Australia's imported goods in order that these goods may pass the tariff barrier. There are normally two ways in which this margin may be widened to the necessary extent.