It is also referred to as demand-supply theory of exchange. The theory stresses that the rate exchange basically relates to the position of balance of payments of the country concerned. A favourable balance of payments leads to an appreciation in the external value of the currency of the country. Unfavourable balance of payments causes a depreciation of the external value.
The balance of payments theory of exchange rate holds that the price of foreign money in terms of domestic money is determined by the free forces of demand and supply in the foreign exchange market. It follows that the external value of a country’s currency will depend upon the demand for and supply of the currency.
The theory states that the forces of demand and supply are determined by various items in the balance of payments of a country. According to the theory, a deficit in the balance of payments leads of a fall or depreciation in the rate of exchange, while a surplus in the balance of payments strengthens the exchange reserves, causing an appreciation in the price of home currency in terms of foreign currency.
A deficit balance of payments of a country implies that demand for foreign exchange exceeds its supply. As a result, the price of foreign money in terms of domestic currency must rise, i.e., the exchange rate of domestic currency must fall.
On the other hand, a surplus in the balance of payments of a country implies a greater demand for home currency in a foreign country than the available supply. As a result, the price of home currency in terms of foreign money rises, i.e., the rate of exchange improves.
In short, the balance of payments theory simply holds that the exchange rates are determined by the balance of payments, connoting demand and supply positions of foreign exchange in the country concerned.
As such, this theory is also designated as “Demand- Supply Theory,” the theory asserts that the rate of exchange is the function of the supply of and demand for foreign money and not exclusively the function of prices obtaining between two countries as asserted by the Purchasing Power Parity Theory which does not take into account invisible items.
According to the balance of payments theory, the demand for foreign exchange arises from the “debit” items in the balance of payments, whereas the supply of foreign exchange arises from the “credit” items.
Since the theory assumes that the demand for and supply of foreign currency are determined by the position of the balance of payments, it implies that supply and demand are determined mainly by factors that are independent of variations in the rate of exchange or the monetary policy.
The theory states that equilibrium rate of exchange is determined at a point where the demand for and supply of the country’s currency are equal Fig. 4 shows this.
In Fig. 4 D is the foreigners’ demand curve of the currency of the country. It shows that when price of the currency in terms of foreign currency, i.e., rate of exchange, is low, demand for the currency is high and vice versa S is the supply curve of currency with foreign exchange market. Its supply rises with price. PM is the equilibrium rate of exchange, given OM demand and supply.
If the country’s export increases, foreigners’ demand for its currency increases, which is graphically shown by the shifting of D curve to Dr Consequently, a new exchange rate is determined as P1M1. This happens when a country has a surplus balance of payments. When a country has a deficit balance of payments, its supply of currency in foreign exchange market will be more than foreigners’ demand for it. Consequently, the rate of exchange will fall.
It goes without saying that charges in demand or supply or both will accordingly influence the equilibrium rate of exchange. This is how the theory brings the determination of the exchange rate within the purview of the general theory of value (or equilibrium analysis).
An Evaluation of the Theory:
The main merit of the theory is that it is compatible with the general theory of value. Furthermore, it shows the determination of the equilibrium rate of exchange under the span of the general equilibrium theory.
Secondly, the theory stresses the fact that there are many predominant forces besides merchandise items (exports and imports of goods) included in the balance of payments which influence the supply of and demand for foreign exchange which in turn determine the rate of exchange. Thus, the theory is more realistic in that the domestic price of foreign money is seen as a function of many significant variables, not just the purchasing power expressing general price levels.
The theory has, however, the following limitations:
- It assumes perfect competition and non-intervention of the government in the foreign exchange market. This is not very realistic in the present day of exchange controls.
- The theory does not explain what determines the internal value of a currency. For this, we have to resort to purchasing power parity theory.
- It unrealistically assumes the balance of payments to be at a fixed quantity.
- According to the theory, there is no causal connection between the rate of exchange and the internal price level. But, in fact, there should be some such connection, as the balance of payments position may be influenced by the price-cost structure of the country.
- The theory is indeterminate at a time. It states that the balance of payments determine the rate of exchange. However, the balance of payments itself is a function of the rate of exchange. Thus, there is a tautology, so what determines what, is not clear.