How Equilibrium Rate of Exchange is Determined?

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Like commodity price and its market, in the foreign exchange market also there is a normal or equal rate of exchange and there is a market or short-term rate of exchange. The equilibrium rate is the “norm” round which the market rate of exchange oscillates.

The equilibrium or normal rate of exchange is determined differently under different monetary standards. The market rate of exchange will reflect the temporary influence, of forces of demand and supply in the foreign exchange market, but it will be oscillating around the normal rate of exchange.

Determination of Equilibrium Rate of Exchange

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According to Scammell “an equilibrium rate is that rate which, over a standard period, during which full employment is maintained and there is no change in the amount of restriction on trade or on currency transfer, causes no net change in the holding of gold and currency reserves of the country concerned.” This definition seems to be very useful for policy, or for the forming o judgements upon a given exchange rate phenomenon.

In simple words, however, the equilibrium rate of exchange is the rate of exchange at which the par value of home currency with foreign currency is exactly maintained, which means it is neither undervalued nor overvalued. Further, it is perpetual and stable over a long period of time, fact, the concept of equilibrium rate of exchange is analogous to the Marshallian concept of ‘normal price’ in the theory of value.

It is the normal rate in the sense that it is determined by the long-term equilibrium in the balance of payments so that, demand and supply of foreign exchange in the long run are appropriately balanced at this rate and the foreign exchange reserves position of the country’ remains intact.

In short, the exchange rate to be an equilibrium rate must be maintained at par with values different currencies.

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Now the question may be raised: What determines the par values? There are various theoretical explanations accepted in this regard due to the fact that, the par values and the equilibrium or normal rate of exchange are determined differently under different situations. They are:

1. Mint Parity Theory,

2. Purchasing Power Parity Theory, and

3. Balance of Payments Theory.

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Below we shall describe each of them with the necessary details.

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