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 on 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 to fall or depreciation in the rate of exchange, while a surplus in the balance of payments strengthens the foreign 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 is exceeding 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 the 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, the 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.
According to the theory, given demand-supply schedules, their intersection determines the equilibrium exchange rate of a currency. It should be noted that the lower the price of a currency, the greater will be the demand for it, and therefore, the demand curve slopes downward. On the other hand, the supply curve slopes upward from left to right indicating that a lowering of the value of price of the currency tends to contract its supply.
DD and SS are the demand and supply curves of a given country’s currency These two curves intersect at a Point P determining PM or OR as the exchange rate where the quantities demanded and supplied are equal (OM).
It is the equilibrium rate. When OR is the rate exchange (high), supply exceeds demand, hence it will be lowered by the excessive supply fore When the rate is lowered, supply will contract and the demand will expand. This process will continue till both are in equilibrium at the point of intersection. The reverse will happen when the exchange rate is lower than the equilibrium rate.
It goes without saying that changes in demand or supply or both will accordingly influence equilibrium rate of exchange. This is how the theory brings the determination of the exchanger within the purview of the general theory of value (or equilibrium analysis).
Merits of the Theory
The main merit of the theory is that it brings the determination of exchange rate problem within the purview of the general equilibrium analysis.
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 a foreign money is seen as a function of many significant variables, not just purchasing power expressing general price levels.
Furthermore, the greatest practical significance of the theory is that, it shows that disequilibrium in the balance of payments position can be corrected by marginal adjustments in the exchange rate by devaluation or revaluation rather than through internal price inflation or deflation as implied by the mint parity theory.
1. The fundamental defect of the theory is that it assumes perfect competition, including no interference with the movement of money from one country to another. This is very unrealistic.
2. 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.
3. The theory advocates that the rate of exchange is the function of the balance of payments. But, in practice it has also been found that the balance of payments position of a country is very much affected by the changes in the rate of exchange. Thus, it is equally true that the balance of payments is the function for the rate of exchange. In this sense, the theory is indeterminate as it confuses as to what determines what.
4. According to the theory, the optimum value of a currency is the gold content embodied in it. This is not true for a flat paper standard. Thus, the demand-supply theory fails to explain the basic value incorporated in currencies.14
5. In fact, the balance of payments theory of exchange rate is merely a truism – a self-evident fact without any causal explanatory significance. Critics argue that if payments must necessarily balance, there can be no meaning to a decline in the exchange rate during an unfavourable trade balance; an uncovered balance simply does not exist.