What is Balance of Payments Theory?

The balance of payments theory is the modern and most satisfactory theory of the determination of the exchange rate. It is also called the demand and supply theory of exchange rate.

According to this theory, the rate of exchange in the foreign exchange market is determined by the balance of payments in the sense of demand and supply of foreign exchange in the market.

Here the term ‘balance of payments’ is used in the sense of a market balance. If the demand for a country’s currency falls at a given rate of exchange, we can speak of a deficit in its balance of payments.

Similarly, if the demand for a country’s currency rises at a given rate of exchange, we can speak of surplus in its balance of payments.

A deficit balance of payments leads to a fall or depreciation in the external value of the country’s currency. A surplus balance of payments leads to an increase or appreciation in the external value of the country’s currency.

According to Ellsworth, “If market forces are allowed to work unimpeded, the demand and supply of foreign exchange establish a rate of exchange that automatically clears the market so that no actual or exposit payments deficit or surplus can appear.”

In the words of Walter, “If the exchange rate is permitted to respond fully to changing supply and demand conditions, the status of the balance of payments of a country tends to determine the value of its currency relative to the currencies of other nations.”

There is a close relation between the balance of payments and the demand and supply of foreign exchange. Balance of payments is a record of international payments made due to various international transactions, such as, imports, exports, investments and other commercial, financial and speculative transactions.

The balance of payments includes all payments made by the foreigners to the nationals as well as all payments made by the nationals to the foreigners. The incoming payments are credits and outgoing payments are debits.

The credits in balance of payments or the export items constitute the supply of foreign exchange; the supply of foreign exchange is made by the exporting countries.

On the other hand, the debits in the balance of payments or the import items constitute the demand for foreign exchange; the demand for foreign exchange arises from the importing countries.

Any deficit or surplus in the balance of payments causes changes in the demand and supply of foreign exchange and thus leads to fluctuations in the exchange rate. When there is deficit in the balance of payments the debits (or the demand for foreign exchange) will exceed the credits (or the demand for foreign exchange).

As a result, the rate of exchange will rise (or the exchange value of domestic currency in terms of foreign currency will fall).

On the other hand, a surplus in the balance of payments means credits (or the supply of foreign exchange), exceeding debits (or the demand for foreign exchange), which in turn, will lead to a fall in the rate of exchange (or a rise in the external value of domestic currency).

The supply of foreign exchange curve, on the other hand slopes upwards from left to right indicating that lower the exchange rate (i.e., rupees per dollar), lower the supply of foreign exchange (dollars) and vice versa.

Initially, the exchange market is in equilibrium at point E where demand and supply curves (D$ and S$) intersect each other. Or rupees per dollar are the equilibrium rate of exchange and OM is the demand and supply of dollars.

If India has deficit balance of payments with America, i.e., India’s imports from America increase, its demand for foreign exchange (dollars) will increase, shifting the demand curve from D$ to D’$.

The new equilibrium is at point E, which shows a rise in the exchange rate from OR to OR1 rupees per dollar. Similarly, when India has a surplus balance, its demand for foreign exchange (dollars) decreases from D$ to D”$.

The new equilibrium is at point E₂ indicating a fall in the exchange rate from OR to OR₂ rupees per dollar. In the similar way, it can be shown that changes in supply or in both demand and supply will influence the equilibrium rate of exchange.