EXCHANGE
RATE
THEORY
THE PURCHASING POWER PARITY
• The purchasing power parity theory was propounded by
Professor Gustav Cassel of Sweden. According to this
theory, rate of exchange between two countries depends
upon the relative purchasing power of their respective
currencies.
• Such will be the rate which equates the two purchasing
powers.
• For example, if a certain assortment of goods can be had for £1 in
Britain and a similar assortment with Rs. 80 in India, then it is clear
that the purchasing power of £ 1 in Britain is equal to the
purchasing power of Rs. 80 in India. Thus, the rate of exchange,
according to purchasing power parity theory, will be £1 = Rs. 80.
• Let us take another example. Suppose in the USA 1 $ purchases a
given collection of commodities. In India, same collection of goods
cost 60 rupees. Then rate of exchange will tend to be $ 1 = 60
rupees.
• Now, suppose the price levels in the two countries remain the same
but somehow exchange rate moves to $1=61 rupees. This means
that 1 US$ can purchase commodities worth more than 60 rupees.
It will pay people to convert dollars into rupees at this rate, ($1 =
Rs. 61), purchase the given collection of commodities in India for 60
rupees and sell them in U.S.A. for 1 dollar again, making a profit of
1 rupee per dollar worth of transactions.
• This will create a large demand for rupees in the USA while
supply thereof will be less because very few people would export
commodities from USA to India. The value of the rupee in terms
of the dollar will move up until it will reach $1 = 60 rupees. At
that point, imports from India will not give abnormal profits. $ 1 =
60 rupees and is called the purchasing power parity between the
two countries.
• Thus, while the value of the unit of one currency in terms of
another currency is determined at any particular time by the
market conditions of demand and supply, in the long run the
exchange rate is determined by the relative values of the two
currencies as indicated by their respective purchasing powers
over goods and services.
• In the above example, if prices in India get doubled, prices in the USA
remaining the same, the value of the rupee will be exactly halved. The
new parity will be $ 1 = 120 rupees. This is because now 120 rupees
will buy the same collection of commodities in India which 60 rupees
did before. We suppose that prices in the USA remain as before. But if
prices in both countries get doubled, there will be no change in the
parity.
• In actual practice, however, the parity will be modified by the cost of
transporting goods (including duties etc.) from one country to another
• In other words, the rate of exchange tends to rest at the point which
expresses equality between the respective purchasing powers of the
two currencies. This point is called the purchasing power parity. Thus,
under a system of autonomous paper standards the external value of
a currency is said to depend ultimately on the domestic purchasing
power of that currency relative to that of another currency.
• In other words, exchange rates, under such a system, tend to be
determined by the relative purchasing power parities of different
currencies in different countries.
• If there is a change in prices (purchasing power of the
currencies), the new equilibrium rate of exchange can be
found out by the following formula;
ER = Er * Pd/Pf
Where, ER = Equilibrium exchange rate
Er =Exchange rate in the reference period
Pd = Domestic price index
Pf = Foreign country’s price index
BALANCE OF PAYMENT THEORY
• BOP theory, is also known as the Demand and Supply theory and the General
Equilibrium theory of exchange rate, holds that the foreign exchange rate, under
free market conditions, is determined by the conditions of demand and supply in
the foreign exchange market.
• Free mechanism of trade is applied here.
• Thus, according to this theory, the price of a currency (exchange rate) is
determined just like the price of any commodity is determined by free play of
the forces of demand and supply in the market
• The value of a currency appreciates when the demand for it
increases and depreciates when the demand fall, in relation to its
supply in the foreign exchange market.
• The extent of the demand for and supply of a nation’s currency in
the foreign exchange market depends on its BOP position.
• When the BOP is in equilibrium, the supply of and demand for the
currency are equal.
• But when there is deficit in the BOP, demand of the currency
exceeds its supply and causes a fall in the external value of the
currency; when there is surplus, supply exceeds demand and causes
a rise in the external value of the currency.
Merits of BOP Theory:
• It treats the problem of the determination of rate of exchange as an
integral part of the general equilibrium theory.
• It is in line with the general theory of value.
• This theory explains that any disequilibrium in the balance of
payments of a country can be corrected through making appropriate
adjustment in the rate of foreign exchange by the way of
devaluation or revaluation.
• It shades lights on various factors affecting the exchange rate
system.
• It focuses on demand and supply and facilitates equilibrium analysis.
The BOP theory provides a fairly satisfactory explanation of the
determination of the rate of exchange. This theory has the following
advantages;
• Unlike the PPP theory, BOP theory recognizes the importance of all
the items in the BOP, in determining the exchange rate.
• This demand and supply theory in conformity with the general theory
of value-like the price of any commodity in a free market, the rate of
exchange is determined by the forces of demand and supply.
• It also indicates that BOP disequilibrium can be corrected by
adjustments in the exchange rate by devaluing or revaluing currency
value.
• This theory brings the determination of the rate of exchange within
the purview of the General Equilibrium Theory. That is why this
theory is also called the general equilibrium theory of exchange rate
determination.
• Haberler says that its greatest weakness is that it assumes balance
of payments to be fixed quantity
