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)


  • 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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