Consider the totals. Bank D has issued 1000D bank notes worth the 200 grains of gold it carriesas an asset, and bank E has issued 750E bank notes worth the 250 grains of gold it carries. ZeroDiscount Value (ZDV) is defined as the price of the bank notes in terms of the quantity of goldheld by the bank. D’s ZDV is 5D per grain and E’s ZDV is 3E per grain. These values areconsistent with 5D = 3E or an exchange rate of 1D = 0.6E. The
prices of gold in terms of D and E have to be the same as the ZDV values when there is convertibility. A grain of goldcosts 5D and also 3E; 5D have to exchange for 3E to prevent arbitrage profits.Thus, if there is convertibility of bank notes into gold, the ratio of the Zero Discount Values of two different bank notes also gives the arbitrage-free exchange rate.Case 2. In a non-convertible system of banking, gold can sell at less than its ZDV. Suppose agrain of gold sells for 0.15 of D’s ZDV, i.e., at 0.75D per grain. Suppose that the discount of E’snotes to its ZDV is the same. That is, gold is 0.15 of E’s ZDV, i.e., 0.45E per grain. In this case,where the discounts are identical, the exchange rate is 1D = 0.6E, since 0.6 x 0.75 = 0.45. Either 1D or 0.6E buy the same number of grains of gold in the market, namely, 1.3333 grains.Furthermore, the backing of the notes at this exchange rate is the same. Both 1D and 0.6E havethe same backing of 0.2 grains.The exchange rate in this non-convertible case remains the same as in the convertible case if andonly if both bank notes sell at the same discount from their respective ZDVs. If they sell atdifferent discounts to their ZDVs, then their exchange rate will no longer be at the rate indicated by the freely convertible benchmark.Case 3. Suppose now that gold priced in D and E notes sells at
discounts to ZDV.Suppose gold sells at 0.15 of its ZDV in D, and it sells at 0.30 of its ZDV in E. Gold is 5D per grain. At 0.15 of its ZDV, it is 0.75D per grain. If gold sells for 0.30 of E’s ZDV of 3E per grain,its price is 0.9E per grain. At the exchange rate of 0.75D to 0.9E, or 1D to1.2E, the same
amounts of gold are exchanged.This means that if we attempt an arbitrage at the observed exchange rates, it will not be profitable. Let us borrow 1D and exchange it for 1.2E. Sell 1.2E and get 1.3333 grains. Exchangethat for 1D and repay the D loan. There is no profit using market rates. Gold prices are consistentwith the exchange rates.It is the exchange rates that are out of equilibrium. This is because the notes are selling atdifferent discounts to ZDV. This shows up in that the
of the notes at this exchange rate isno longer the same. 1D has a backing of 0.2 grains, and 1.2E has a backing of 0.4 grains.If D and E are inconvertible and D sells at a larger discount to ZPV, D’s exchange rate moveshigher compared to the convertible case. If the price of gold in D notes is relatively lower thanthe price of gold in E notes as reflected in the larger discount from ZDV, then the value of Dnotes is relatively larger as compared with the convertible case and the equal discount case. Thismeans that the D notes appear overvalued and the E notes undervalued. This coincides with thelower gold backing of the D notes at the new exchange rate.