Working Paper Series

J. M. Keynes’s Foreign Exchange Rate Theory? : A Reading of 1946’s
Posthumous Paper

Zhao Zhuang and Yoshihiro Yamazaki

Graduate School of Economics
Fukuoka University

GEWP－2018－001

Graduate School of Economics
Fukuoka University
8-19-1 Nanakuma，Jonan－ku，Fukuoka，JAPAN 814-0180

J. M. Keynes’s Foreign Exchange Rate Theory? : A Reading of 1946’s
Posthumous Paper
Zhao Zhuang and Yoshihiro Yamazaki

Abstract
1946’s paper of Keynes was published posthumously. The paper analyzed American
balance of payment after World War II and showed some expectation of the economy’s future.
Though it is a very practical analysis, we can deduce Keynes’s insight into foreign exchange
rate of his last days. Keynes wrote about foreign exchange rate 1923’s book first. From thattime, he continually kept the critical position to purchasing power parity (PPP). Keynes
separated internal and external equilibria in 1930’s book and regarded balance of payment
rather than PPP as the determining factor of foreign exchange rate. Because he published
1936’s book and showed the possibility of plural levels of production, his belief that foreignexchange rate must be determined with the other economic variables endogenously wassupposedly established. Keynesian spirit about foreign exchange rate gives us a critical pointof view to the revival of PPP in contemporary macroeconomic theories.

JEL classification: B22, B27, B31, F41.

Keywords: J. M. Keynes, foreign exchange rate, balance of payment, internal and external
equilibria, production levels, purchasing power parity.

11. Introduction
A paper named ‘the Balance of Payment of the United States’ was published in 1846
just after J. M. Keynes’s death. Keynes wrote about foreign exchange rate in 1923’s book first.
From then, Keynes continually kept a critical position to the theory of purchasing power parity(PPP). Keynes thought that PPP was appropriate in the long run while economic power
balance was more important in determining foreign exchange rate of the short run. Keynes
also distinguished internal and external equilibria 1. And he insisted we should give internalbalance, which means full employment, a priority over external trade balance.
Even in theoretical level, Keynes came to emphasize balance of payment as thedetermining factor of foreign exchange rate rather than PPP. Keynes wrote that not thechange of price levels of both countries but balance of payment would give more effect onexchange rate in 1930’s book. By the publication of General Theory in 1936, Keynes’s
theoretical perspective was limited in one country’s economy. He, however, kept his concern
on the relation between balance of payment and foreign exchange rate.
Keynes’s posthumous paper is, of course, treating American balance of payment. It iswritten as an analysis of contemporary affairs of Keynes’s days. Nevertheless we should pay
attention to the fact that it also refers to the background of foreign exchange rate and it waswritten after 1936’s book. We will make a reading of the paper as telling something like
Keynes’s theory of foreign exchange rate here.
2．General Theory and 1946’s paper
Keynes pointed two agendas about American economy. One is the capacity of Britain
exports to the United States. The other is the capacity of the United States to absorb goods
and services from the rest of the world. Keynes expected IMF could clear the transaction
among countries of all over the world. If it is achieved, bilateral arrangement will not benecessary between the United Kingdom and the United States. And Keynes told that he would
concentrate into America’s current account. His purpose is not a definite prediction but a
gradual understanding of the situation.
Keynes said that when we saw the figures of pre-war era, we could notice it had not been
so favorable. Keynes divided the period into three stage. The average current accounts are1

In this meaning, we can say that Keynes’s approach at this stage of thinking is similar to

the theory of fundamental equilibrium exchange rate (FEER).
2

$356 million, $98 million and $231 million. Anyway these figures are less favorable than thoseof the United Kingdom in the same period. In those days, the United Kingdom invested inforeign countries.
During the great depression, American imports was depressed comparing with exports.
And Keynes wrote we had to understand the US’s creditor position to the rest of the world.
This position is based on the country’s large reserve of gold. The United States built the hugegold holdings during World War II. The US’s administration blocked the country’s asset
throughout the war. After the war the statistics become available for us. At the same time, theUS Treasury published the census of foreign-owned assets in the United States.
The sterling prices of goods became doubled than the pre-war period. This ratio is muchhigher than dollar prices. The difference of price level made the US’s exports to become muchlarger. When exports increased, then productions in America must increase. And the increaseof productions required imports of raw materials. Keynes explained this relation by using theterms “the great increased activity of the American industrial machines and its increased
consumption of imported raw materials 2 ”. Here Keynes’s theory of determination ofproduction level which he proposed in 1936’s book.
The theory of purchasing power parity (PPP) insists that foreign exchange rate isdetermined by purchasing power of currencies as domestic price levels are given. The given
price levels mean that both supply amount and demand amount are given. It is supposed thatPPP originally premises full-employment price level 3. Keynes, however, introduced the theoryof determination of production level. This made possible him to think the situation in which
production level could change when foreign exchange rate changed. Because of this, foreignexchange rate and production level come to have interactions. Keynes attained new standpointof criticizing PPP.
3. The US’s balance of payment through World War II
American government made actions to decrease its prolonged unemployment during
the 1930s. After World Wat II, economies of the rest of the world recovered and their imports
from the United States increased. The increase of the US’s exports, however, was supported
by Lend-Lease. Behind this situation, there was a fact that prices of agricultural produce andraw materials was much higher that their world prices. In addition to that, the wage level of2

Keynes [1946], 178.

3

This is the reason why PPP revived in contemporary macroeconomics like new open

economy macroeconomics.
3

the United States is two and a half times higher than Britain’s. Therefore, loans to foreigncountries and subsidies to exports from America were necessary for American exports.
Keynes separated visible and invisible exports. The United States had already enjoyedan adverse balance of invisible trade even in the pre-war era. Keynes, however, expected afavorable change for America in the post-war era concerning with shipping because America
kept much larger holdings of ship tonnage. On the other hand, he said that American analysist
forecast a continual deficit in travel because of increase of American tourists.
After this, Keynes emphasized the importance of current receipts of interest anddividend from other countries. He picked up a month’s bank letter as a sample. He knew thatthe analysis was very difficult because these receipts and payments were closely connectedwith governmental loans and its free gifts to other countries. The countries which drew moneyfrom IMF had to pay interest and the countries which invested money in IMF could receive
dividend. Keynes also referred to United Nations Relief and Rehabilitation Administration(UNRRA) many times. In addition to interest payments, amortization of capital has to be also
taken into account. In American case, the total account of invisible balance including interestand dividend was supposed to be negative than favorable. Keynes told that Americancommercial policy could improve the balance.
Keynes mentioned the situation of American balance from 1924 to 1930. Exports ofgoods showed enough surplus but the deficit of shipping and traveling reached a half of thesurplus.
4. Keynes’s view on economic future of the United States
Keynes wrote that three elements were important in expecting American future ofbalance of payment. The United States had liquid assets in the shape of ear-marked gold, bankbalances and market securities. Keynes said that these assets were available to cover thebalance of payment favorable to the United States. Secondly America also had contributions
to UNRRA and credits for Lend-Lease settlements. Thirdly, other USSR, Canada and South
Africa came to output more gold than before. So the rest of the world other than the US wasgetting more power of payments in those days.
Keynes, after this, made a prediction. In post-war era, other countries than the UnitedStates would demand more and more dollar. This could cause “the chances of the dollar
becoming dangerously scarce 4”. Then “America will lose gold 5”. And Keynes progress his4op. cit., 185.

5Ibid.
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prediction further into the long run. He said we had to have doubts about the old belief thatinvisible hand would lead us to equilibrium. The United States, Keynes told, was “becoming
a high-living, high-cost country beyond any previous experience 6”. Keynes wrote 7;
Unless their internal, as well as their external, economic life is to become paralysed by
the Midas touch, they will discover ways of life which, compared with the ways of the lessfortunate regions of the world, must tend towards, and not away from, externalequilibrium.
We can see that Keynes foresaw America’s future as an ordinal country. Keynes did not
believe that import tariffs and export subsidies, which he called “the classical medicine 8”,
would work by themselves. Keynes, nevertheless, did not necessarily know the fittest
alternative. He wrote 9;
It is for this reason that, speaking in the House of Lords, I claimed that “Here is anattempt to use what we have learnt from modern experience and modern analysis, not todefeat, but to implement the wisdom of Adam Smith.”Though Keynes referred to Bretton Woods system here, he also, “No one can be certainof anything in this age of flux and change. 10” Keynes defined our age as “when our commandover the production if material satisfactions is the greatest ever” 11 and “when more than
before we should be able to afford these satisfactions 12 ”. On the contrary, the “scope forindividual decision and choice 13” is “diminishing 14”. We can see “an underlying contradictionin every department of our economy 15”. “No plan will work for certain in such an epoch. 16”

6Ibid.

7Ibid.

8Ibid. 186.

9Ibid.

10Ibid.

11Ibid.

12Ibid.

13Ibid.

14Ibid.

15Ibid,16Ibid.
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Therefore we have to progress in a try-and-error way. Keynes wrote down hopeful words
finally 17;
Meanwhile for us the best policy is to act on the optimistic hypothesis until it has
been proved wrong. We shall do well not to fear the future too much. Preserving all due
caution in our own activities, the job for us is to get through the next five years inconditions which are favourable and not unfavourable to the restoration of our fullproductive efficiency and strength of purpose, of our prestige with others and of ourconfidence in ourselves.
5. Conclusion
PPP says that foreign exchange rate is determined so as to equalize purchasing powersof two countries. In other words, it considers only the price levels in the two currencies. We
think Keynes’s discomfort was directed to this point mainly. He thought various factors whichconstructed balance of payment would wholly affect foreign exchange rate.

It is especially true after Keynes published General Theory, where he told a country’s

production level was not fixed. After 1946’s paper, Keynesian economists built many kinds ofKeynesian open economy macroeconomic models, where foreign exchange rate is determined
endogenously. This makes a big difference to PPP, which determines foreign exchange rate
separately apart from the other variables of the economy.

References
Keynes, J. M., A Tract on Monetary Reform, London: Macmillan, 1923.
Keynes, J. M., A Treatise on Money, London: Macmillan, 1930.

Keynes, J. M., The General Theory of Employment, Interest and Money, London:
Macmillan, 1936.

Keynes, J. M., ‘The Balance of Payment of the United States’, The Economic Journal,
June 1946, 172-187.

17Ibid. 186-187.
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