Friday, August 28, 2009
Balance of Payments Theory of Foreign Exchange Rates
According to this theory, under free exchange rates, the exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an unfavourable balance of payments reduces the exchange rate. Thus the theory implies that the exchange rate is determined by the demand for and the supply of foreign exchange.
The demand for foreign exchange arises, from the debit side of the balance of payments. It is equal to the value of payments made to the foreign country for goods and services purchased from it plus loans and investments made abroad. The supply of foreign exchange arises from credit side of the balance of payments. It equal all payments made by the foreign country to our country for goods and services purchased from us plus loan disbursed and investments made in this country. The balance of payment balances if debits and credits are equal. If debits exceed credits, the balance of payments is unfavourable. On the contrary, if credits exceed debits, it is favourable. When the balance of payment is unfavourable, it means that the demand for foreign currency is more than its supply. Thus causes the external value of the domestic currency to fall in relation to the foreign currency. Consequently the exchange rate falls. On the other hand, in case the balance of payments is favourable the demand for foreign currency is less than its supply at given exchange rate. This cause the external value of domestic currency to rise in relation to the foreign currency. Consequently the exchange rate rises.
When the exchange rate falls below the equilibrium exchange rate in a situation of adverse balance of payments, exports increase and the adverse balance of payments is eliminated, and the equilibrium exchange rate is re-established. On the other hand when under a favourable balance of payments situation, the exchange rate rises above the equilibrium exchange rate, exports decline, the favourable balance of payments disappears and the equilibrium exchange rate is re-established. Thus at any point in time the rate of exchange is determined by the demand for and supply of foreign exchange as represented by the debit and credit side of balance of payments. “Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate and at the ruling rate the balance of payments balances from day to day or from moment to moment”.
DD is the demand curve for foreign currency. It slopes downward to the left because when the rate of exchange rises, the demand for foreign currency falls and vice versa. SS is the supply curve of foreign exchange which slopes upward from left to right. This is because when the exchange rate falls, the amount of foreign currency offered for sale will be less and vice versa. The two curves intersect at E. Where OR equilibrium exchange rate is determined. At this rate the quantity of foreign exchange demanded and, supplied equals OQ. E is also the point where the balance of payments is an equilibrium. Any exchange rate above or below OR will mean disequilibrium in the balance of payments. Suppose the exchange rate rises to OR1. The demand for foreign exchange R1A is less than its supply R1B. It means that there is favourable balance of payments. When the exchange rate is more than the equilibrium rate, exports decline and imports increase. Consequently the demand for foreign exchange will rise and the supply will fall. Ultimately the equilibrium exchange rate OR will be restored where demand and supply of foreign exchange equals at point E. In the opposite case when the exchange rate falls below the equilibrium rate to OR2 the demand for foreign exchange R2H is greater than its supply R2G. It implies an unfavourable balance of payments. But fall in the exchange rate leads to increase in exports and decline in imports. As a result the demand for foreign currency starts falling and supply, starts rising till the equilibrium exchange rate OR is re-established with the quantity of demand and supply of foreign exchange at point E.
The balance of payments theory has been criticised by economists on the following grounds.
1. The main defect of the theory is that the balance of payments is independent of the exchange rate. In other words, the theory states that the balance of payments determines the exchange rate. This is not wholly true because it is change in the exchange rate that being about equilibrium in the balance of payments.
2. Another defect of the theory is that it neglects the role of the price level in influencing the balance of payments of a country and hence its exchange rate. But the fact is that price changes do affect the balance of payments and the exchange rates between countries.
3. The theory is based on assumption of free trade. This is unrealistic because free trade is not practised these days. Governments impose number to encourage exports. This is how they try to correct disequilibrium in the balance of payments.
4. The theory pre-supposes that there is an equilibrium exchange rate where balance of payments balances. This is a truism. But the equilibrium exchange rate may not be one of balance of payments equilibrium. Infact exchange rates between countries continue to prevail under conditions of surplus or deficit in the balance of payments to be in equilibrium over the long run.Despite these criticisms the balance of payments theory is the most satisfactory explanation of the determination of exchange rate. Tags: International Relations
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