When the currencies of two countries are on metallic standard (gold or silver standard), rate of exchange between them is determined on the basis of parity of minorities between currencies of the two countries. Thus, the theory explaining the determination of exchange between countries which are on the same metallic standard (say gold coin standard), is known the Mint Parity Theory of foreign exchange rate.
By mint parity is meant that the exchange rate is determined on a weight-to-weight basis of two currencies, allowances being made for the parity of the metallic content of the two currencies.' Thus, the value of each coin (gold or silver) will depend upon the amount of metal (geld or silver) contained in the coin; and it will freely circulate between the countries. For instance, before World War I, England and America were simultaneously on a full-fledged gold standard.
While gold sovereign (Pound) contained 113.0016 grains of gold, the gold dollar contained 23.2200 grains of gold standard purity. Since the mint parity is the reciprocity of the gold content ratio between the two currencies, the exchange rate between the American dollar and the British Sovereign (Pound) based on mint parity, was 113.0016/23.2200, i.e., 4.8665. That means, the exchange rate: 1 = 4.8665, can be defined as the mint parity exchange between the pound and the dollar.
Thus, under gold standard conditions the exchange rate tended to stay close to the ratio of gold values of the currencies or mint parity. The exchange rate was, however, free to fluctuate within limits called the gold points or series. Since gold could be freely bought and sold between countries, these gold points were determined by the costs of insurance, transportation and handling charges incurred in the shipment of gold. At the gold points the supply and demand schedule becomes perfectly elastic.
OE is the equilibrium rate of exchange as per the mint parity (under gold standard system) at which the demand for and supply of foreign exchange (dollar from Britain's point of view) are equal. Further, it can be seen that a change in the supply schedule for dollars within the interval ZT (or ad) would simply result in a divergence of the exchange rate from mint parity; a shift in the demand for dollars within the range RQ (or bs) would similarly result in a deviation of the rate from mint parity.
Thus, exchange rate may rise upto OU or fall upto OL. But it cannot rise beyond the gold export point or fall below the gold import point, because at these points the demand for and supply of foreign exchange (pound in our illustration) becomes perfectly elastic by the outflow or inflow of gold. Therefore, the supply curve becomes SS' and the demand curve dd' in the diagram.
The point s/a is regarded as "gold export point"; at this point the demand curve becomes perfectly elastic. Similarly, the point d/b is regarded as "gold import point"; at this point the supply curve becomes perfectly elastic. U and L thus, set the limit to a deviation of equilibrium exchange rate from mint parity. And the equilibrium will be restored conceptually in this situation when the country
gaining gold finds its money supply increasing and prices and incomes rising, while the reverse will happen in the case of a gold exporting country.
The specie (gold) points are important in the determination of foreign exchange rate under g( standard because they give us an idea of the maximum fluctuations to which the exchange rate the foreign exchange market is subject from day-to-day. They also explain why and how the actual rate of exchange differs from that normal rate of exchange which is determined by the mint parity criterion.
Today, however, the method of determining currency values in terms of gold content or m parity is obsolete for the obvious reasons that:
(i) none of the modern countries in the world is gold or metallic standard,
(ii) free buying and selling of gold internationally is not permitted various governments. As such it is not possible to fix par values in terms of gold content or mint parity, and
(iii) most of the countries today are on paper standard or Fiat currency system.