Theories of Foreign Exchange

Every country has a currency different from others. There is no common medium of exchange. It is this feature that distinguishes international trade from domestic. Suppose the imports and exports of a country are equal, the demand for foreign currency and its supply conversely, the supply of home currency and the demand for it will be equal. The exchange will be at par. If the supply of foreign money is greater than the demand it will fall below par and the home currency will appreciate. On the other hand, when the home currency is in great supply, there will be more demand for the foreign currency. This will appreciate in value and rise above par.

Theories of Exchange Rate

Economists have propounded the following theories in connection with determination of rate of exchange (Theories of Foreign Exchange). 

1. Mint Par Theory

Mint par indicates the parity of mints or coins. It means that the rate of exchange depends upon the quality of the contents of currencies. It is the exact equivalent of the standard coins of one country expressed in terms of standard coins of another country having the same metallic standards the equivalent being determined by a comparison of the quantity and fineness of the metal contained in standard coins as fixed by law. A nation’s currency is said to be fully on the gold standard if the Government:

  1. Buys and sells gold in unlimited quantity at an official fixed price.
  2. Permits unrestricted gold movements into and out of the country.

In short, an individual who holds domestic currency knows in advance how much gold he can obtain in exchange for it and how much foreign currency this gold will buy when exported to another country. Under this circumstances, the foreign exchange rate between two gold standard countries’ currencies will fluctuate within the narrow limits around the fixed mint par. But mint par is meant that the exchange rate is determined on the weight-to-weight bases of the metallic contents of the two currency units, allowance being given to the purity of the metallic content. The mint parity theory of foreign exchange rate is applicable only when the countries are on the same metallic standards. So, there is no fixed mint par between gold and silver standard country.

2. Purchasing Power Parity Theory

This theory was developed after the break down of the gold standard post World War I. The equilibrium rate of foreign exchange between two inconvertible currencies in determined by the ratio between their purchasing powers. Before the first World War, all the major countries of Europe were on the gold standard. The rate of exchange used to be governed by gold points. But after the I World War, all the countries abandoned the gold standard and adopted inconvertible paper currency standards in its place. The rate of foreign exchange tends to be stabilized at a point at which there is equality between the respective purchasing powers of the 2 countries. For eg; say America and England where the goods purchased for 500 $ in America is equal to 100 pounds in England. In such a situation, the purchasing power of 500 US $ is equal to that of 100 English pounds which is another way of saying that US $500 = 100, or US $5=1 pound. If and when the rate of foreign exchange deviates from this nor, economic forces of equilibrium will come into operation and will bring the exchange rate to this norm. The price level in countries remain unchanged but when foreign exchange rate moves to 1=$5.5, it means that the purchasing power of the pound sterling in terms of the American dollars has risen. People owing Pounds will convert them into dollars at this rate of exchange, purchase goods in America for 5$ which in England cost 1 pound sterling and earn half dollar more. This tendency on the part of British people so to convert their pound sterling into dollars will increase, the demand for dollar in England, while the supply of dollar in England will decrease because British exports to America will fall consequently the sterling price of dollar will increase until it reaches the purchasing power par, i.e. 1=US $5. On the other hand, of the prices in England rose by 100 percent those on America remaining unaltered, the dollar value of the English currency will be halved and consequently one sterling would be equal to 2.5 $. This is because 2 unite of English currency will purchase the same amount of commodities in England, as did one unit before. If on the other hand, the prices doubled in both the countries, there would be no exchange in the purchasing power parity rate of foreign exchange, this , in brief is the purchasing power parity theory of foreign exchange rate determination.

The change in the purchasing power of currency will be reflected in the exchange rate.

Equilibrium Exchange Rate (ER) =Er * ( Pd / Pf)

Where;

  • ER = Equilibrium Exchange Rate
  • Er = Exchange Rate in the Reference period
  • Pd = Domestic Price Index
  • Pf = Foreign currencies price index.

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3. Balance of Payments Theory

According to this approach, foreign exchange rate is determined by independent factors no related to international price levels, and the quantity of money has asserted by the purchasing power parity theory. According to this theory, an adverse balance of payment, lead to the fall or depreciation of the rate of foreign exchange while a favorable balance of payments, by strengthening the foreign exchange, causes an appreciation of the rate of foreign exchange. When the balance of payments is adverse, it indicates a situation in which a demand for foreign exchange exceeds its supply at a given rate of exchange consequently, its price in terms of domestic currency must rise i.e., the external value of the domestic currency must depreciate. Conversely, if the balance of payment is favorable it means that there is a greater demand for domestic currency in the foreign exchange market that can be met by the available supply at any given rate of foreign exchange. Consequently, the price of domestic currency in terms of foreign currency rises i.e., the rate of exchange moves in favor of home currency, a unit of home currency begins to command larger units of the foreign currency than before.

Balance of Payment theory, also known as the Demand and Supply theory, holds that the foreign exchange rate, under free market conditions is determined by the conditions of demand and supply in the foreign exchange market. According to this theory, the price of a commodity that is , exchange rate is determined just like the price of any commodity is determined by the free play of the force of demand and supply.

“When the Balance of Payment is equilibrium, the demand and supply for the currency are equal. But when there is a deficit in the balance of payments, supply of the currency exceeds its demand and causes a fall in the external value of the currency. When there is a surplus, demand exceeds supply and causes a rise in the external value of the currency.”

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Credit: International Finance-MGU

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