Different theories have been developed to explain the determination of rate of exchange. They are: 1. Mint Parity theory 2. Purchasing power parity theory 3. Balance of payments theory
1. Mint Parity Theory:
Mint parity theory explains the determination of exchange rate between the two gold standard countries. In a country on gold standard, the currency is either made of gold or its value is expressed in terms of gold. According to the mint parity theory, the exchange rate under gold standard is equivalent to the gold content of one currency relative to that of another. This exchange rate is also known as mint rate.
A country is said to be on the gold standard if the following conditions are satisfied:
(a) The standard monetary unit is defined in terms of gold, i.e., either it is made of gold of given purity and weight, or it is convertible into gold at fixed rate.
(b) The government buys and sells gold in unlimited quantity at officially fixed price,
(c) There are no restrictions on the export and import of gold.
The mint parity theory states that under gold standard, the exchange rate tends to stay close to the ratio of gold values or the mint parity or par. In other words, the rate of exchange between the gold standard countries is determined by the gold equivalents of the concerned currencies.
According to S.E. Thomas, “The mint par is an expression of the ratio between the statutory bullion equivalents of the standard monetary units of two countries on the same metallic standard”.
Thus, when the currencies of different countries are defined in gold, the exchange rate between such countries is automatically determined on a weight-to-weight basis of the gold content of their currencies, after making allowance for the purity of such gold content of these currencies.
For example, before World War I, both England and America were on gold standard. The British pound contained 113.0016 grains of gold and the American dollar contained 23.2200 grains of gold. The exchange rate between the British pound and the American dollar was determined on the basis of the mint parity and was equal to the ratio of the gold content of the two currencies. Thus,
Fluctuations in Exchange Rate:
Mint rate is a long run phenomenon. In the long run, the forces of demand and supply of foreign exchange tend to be in equilibrium and the exchange rate has the tendency to become equal to the ratio of gold values, or the mint parity. In reality, the demand and supply forces experience changes, and as a result, the market rate of exchange may differ from the long run mint parity equilibrium.
This variation in the exchange rate is within the well-defined limits, called gold points. Thus, gold points refer to the limits within which the market rate of exchange between two countries on gold standard fluctuates from the mint parity equilibrium level. The upper gold point indicates the upper limit and the lower gold point indicates the lower limit.
The gold points are determined by the costs of shipping gold (such as, transportation, packing, insurance charges) from one country to another. For example, an American importer willing to buy pounds with dollars to pay for his imports from England will pay a price above the mint parity (i. e., more than 4.866 dollars per pound) if necessary.
But that price must not be greater than the cost of buying gold in America and shipping it to England to acquire pounds. Similarly, an American exporter willing to sell pounds for dollars will be ready to accept a price below the cost of using his pounds to import gold from England and then sell this gold in America to acquire dollars.
Thus, the upper gold point is determined by adding the cost of shipping gold to the mint parity rate of exchange and the lower gold point is obtained by deducting the cost of shipping gold from the mint parity rate of exchange. If, for example, the mint parity rate of exchange is 1 pound = 4.866 dollars and the shipping gold is 2 cent per pound, then-
the upper gold point- 1 pound = 4.866 + .02 = 4.886 dollars;
the lower gold point- 1 pound = 4.866 – .02 = 4.846 dollars;
The upper gold point is also called gold export point because it refers to the critical rate of exchange above which gold will be exported. Similarly, the lower gold point is called gold import point because it indicates the critical rate of exchange below which gold will be imported.
Under the gold standard, the exchange rate between two currencies cannot vary above the upper gold point and below the lower gold point. It will remain within their two limits. Thus, under gold standard, since the limits to exchange rate variation are very narrow, we can talk in terms of a fixed exchange rate.
In Figure 2, curve DD represents demand for pounds (or supply of dollars) and curve SS represents supply of pounds (or demand for dollars). OM (i.e., £1 = $4,866) is the mint rate and it costs $0.02 to ship $ 1 worth of gold between America and England. Thus, £1 = $4,866 (OU) is the gold export point and £1 = $4,846 (OL) is the gold import point.
Since the market exchange rate cannot rise above gold export point (OU) or fall below the gold import point (OL), the demand and supply curves become infinitely elastic at the gold points. Hence, the demand curve for pound becomes UABC, and the supply curve for pound becomes LPQR, instead of DD and SS respectively. Thus, cost of shipping gold determines the upper and lower limits (OU and OL respectively) beyond which the exchange rate cannot move.
Variations in Exchange Rate:
As long as the shifts in demand and supply schedules remain within the limits of gold points (i.e. the demand for pounds changes within dd1 range and supply of pounds changes within ss1 range), the market rate of exchange will diverge from the mint rate (OM) and the variation will remain within the limits of upper gold point (OU) and lower gold point (OL).
If the shifts in demand and supply curves are substantial and go beyond the limits of gold points (i.e., the changes in demand and supply of pound exceed the dd1 and ss1 ranges respectively), there will be gold flow which, in turn, will restore equilibrium in the exchange market and keep the exchange rate within the limits of gold points.
For example, if in America, as a result of deficit balance of payments with England, the demand for pounds increases beyond point d1, the American buyers of pounds instead of purchasing pounds at a rate higher than £1 = $4.886, will find it profitable to meet this excess demand by exporting gold to England. Thus, the exchange rate will not rise beyond the gold export point OU.
Similarly, if, in America as a result of surplus balance of payments with England, the supply of pounds increases beyond point s1, the American sellers of pounds, instead of selling the pounds at a rate lower than £1= $4,846, will prefer to use the pounds to import gold from England. Thus, the exchange rate will not fall below the gold import point OL. Hence, under the gold standard, the market rate of exchange fluctuates within the limits set by the gold points and never crosses them.
In modern times, the method of determining exchange rates in terms of gold contents or mint parity has become obsolete for the following reasons:
(a) None of the countries in the world is on gold standard.
(b) Free buying and selling of gold at international level is not allowed by the governments.
(c) Most of the countries are on paper standard or fiat currency standard.
(d) The operation of gold standard depends on flexible internal prices. But, the modern governments pursue independent domestic price and employment policies without considering exchange rate.
Under such conditions, it is not possible to fix the values of various currencies in terms of gold content or mint parity and determine the gold points to which fluctuations in the rate of exchange are confined.
Purchasing power parity theory explains the determination of exchange rate and its fluctuations when the countries are on inconvertible paper standard. The theory was first propounded by wheatlay in 1802, but the credit for properly developing the theory in the present form goes to Gustav Cassel who gave its systematic statement in 1918.
The theory is based on the fundamental principle that the different currencies have purchasing powers in their respective countries. When the domestic currency is exchanged for the foreign currency it is, in fact, the domestic purchasing power which is exchanged for the foreign purchasing power. Thus the most important factor determining the exchange rate is the relative purchasing power of the two currencies.
According to the purchasing power parity theory, under the system of inconvertible paper currency, the rate of exchange is determined by the relative purchasing powers of the two currencies in their respective countries.
A country is said to be on inconvertible paper standard when- (a) money is made of paper or some cheap metals and its face value is greater than its intrinsic value; (b) the money is not convertible into gold; (c) the purchasing power of money is not maintained at par with that of gold or any other commodity; (d) the currency may not be fully backed by gold or any other metallic reserves; (e) the currency system is nationalistic in the sense that there is no link between the different paper currency systems adopted by different countries. Under such conditions, the rate of exchange between the two currencies must equalise the purchasing power of both the countries.
The purchasing power parity theory has been defined by different economists in the following manner. According to Cassel, “The rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing power of the currencies.” In the words of G.D.H Cole, “The relative values of national currencies especially when they are not on gold standard, in the long run, are determined by their relative purchasing powers in terms of goods and services.”
According to Thomas, “The rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two countries. This point is called the purchasing parity.” According the Kurihara, “The theory seeks to explain that under system of autonomous paper standard, the external value of a currency depends ultimately and essentially on the domestic purchasing power of that currency relative to that of another currency.”
The absolute version of the purchasing power parity theory explains the determination of rate of exchange between the two countries on inconvertible paper standard. According to the absolute version, the exchange rate should normally reflect the relationship between the internal purchasing power of various national currency units.
In other words, the rate of exchange should be equal to the ratio of the outlay required to purchase a particular set of goods at home as compared with what it would be abroad. For example, suppose a set of goods costs Rs. 5000 in India and $ 1000 in the U.S.A.
Thus, according to the absolute version of the purchasing power theory, the rate of exchange is determined by the ratio of internal purchasing power of the foreign currency and the internal purchasing power of the domestic currency.
The ratio of internal purchasing power of the two currencies is called the purchasing power parity. The rate of exchange will be in equilibrium when the purchasing power of money is equal in all the trading countries.
The relative version of the purchasing power parity theory explains the measurement of the changes or fluctuations in the rate of exchange. It deals with the relationship between changes in internal purchasing power and the changes in exchange rate.
According to the relative version, the change in the equilibrium rate of exchange depends upon the change in the ratio of the internal purchasing powers of the concerned currencies.
The new and changed rate of exchange is determined by multiplying the old purchasing power parity by the ratio of the changes in the internal purchasing powers of the currencies. According to Cassel, “When two currencies have been inflated, the new normal rate of exchange will be equal to the old rate multiplied by the quotient between the degree of inflation of both the countries.”
Symbolically, the relative version of the purchasing power parity theory can be expressed as:
The equilibrium rate of exchange (i. e., R1) calculated in this way, represents new parity between the currencies. This parity is again the purchasing power parity because it is determined by the quotients of the purchasing powers of the different currencies.
Thus, the relative version of the purchasing power parity theory leads to the following conclusions:
(i) A currency maintains its purchasing power parity if it depreciates by an amount equal to the excess of domestic inflation over foreign inflation-
(Currency depreciation) = (Domestic inflation) – (foreign inflation)
(ii) The price level in a country and its rate of exchange move in the opposite direction. For example, if the price level in India rises, the rupee exchange rate in terms of foreign currency will fall and vice versa.
(iii) If the price level in country A rises and the price level in country B remains unchanged, the exchange rate will move in favour of country B and against country A and vice versa.
(iv) If the price level in country A rises and the price level in country B falls, the exchange rate will move in favour of country B and against country A vice versa.
(v) If the price levels in both the countries rise (and fall) at the same rate, there will be no change in the rate of exchange.
The relative version of the purchasing power parity theory is graphically represented in Figure 3. D $ and S $ are the initial demand and supply curves of dollars respectively. The equilibrium rate of exchange is rupees OR0 per dollar in the base year. Suppose, in the current year, the price level in India rises and the price level in the U.S.A. remains constant.
The rise in the Indian price level makes the India exports less attractive to the foreigners, and, at the same exchange rate, OR0, imports from abroad become more attractive in India because the import prices in Indian rupees will remain constant while the prices of the domestic products are rising.
As a result the demand for dollars increases and the supply of dollars decreases. The dollar demand curve shifts forward from D $ to D’ $ and the dollar supply curve shifts backward from S $ to S’ $. With no intervention in the foreign exchange market, the new equilibrium rate of exchange in the current year will be OR1 rupees per dollar which will be higher than that in the base year (i.e., OR0) and will represent the new purchasing power parity.
The dollar exchange rate will rise by the same percentage amount as the rise in the Indian price level. This higher dollar exchange rate will keep the quantities of Indian exports and imports unchanged at their original levels.
The purchasing power parity theory has been criticised by number of economists like, Aftalion, Hawtrey, Taussig, Pigou, Harris, Keynes, etc.
Important defects of the theory are given below:
I. Defects of Index Numbers:
According to the Purchasing power parity theory, the rate of exchange is based on the purchasing power of the currency units of the two countries and the purchasing power of the currencies is measured by the price index numbers.
The critics point out that the price index numbers have many defects:
(a) The price index numbers use past prices and do not deal with present prices.
(b) The price index numbers in different countries include different sets of commodities.
(c) Price index numbers also include those commodities – which are not traded internationally.
(d) The price index numbers may be based on different weights assigned to different commodities.
(e) Price index numbers in different countries have different base years and are not fully comparable.
Because of these defects, the price index numbers are not reliable and do not provide true picture of the relative purchasing power of different countries.
II. No Direct Relation between Price Level and Exchange Rate:
The purchasing power parity theory assumes a direct relationship between the purchasing powers of currencies of two countries and the rate of exchange between them. But, in reality, there exists no such direct and exact relation between the two. Apart from the purchasing power, there are many other factors, such as, tariff speculation, capital flows, etc., which influence the rate of exchange.
According to this theory, the knowledge of base rate (i.e., the old equilibrium rate) is necessary to calculate the new equilibrium rate of exchange. But, it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.
IV. Price Level not Reflected by Exchange Rate:
According to this theory, the exchange rate should reflect the prices of all goods and services in an economy. But, only some of the goods and services enter international trade. All other goods, traded internally, have no direct bearing on the exchange rate. As Keynes puts it, Confined to international-traded commodities, the purchasing power parity theory becomes an empty truism.
The purchasing power parity theory assumes that changes in price level cause changes in the exchange rates and not the other way round. In other words, according to this theory, changes in the exchange rates do not have any influence on the price level. But, this is not correct.
Empirical evidence shows that the exchange rates govern the prices rather than the prices govern the exchange rates. According to Halm, the price levels follow rather than precede the changes in exchanges rates. As he says, “A process of equilisation through arbitrage takes place so automatically that the national prices of commodities seem to follow rather than determine the movements of exchange rates.”
VI. Unrealistic Assumption of Free Trade:
This theory is based on the unrealistic assumption of free trade and absence of exchange control. In the real world, state restrictions on the international trade, such as import and export duties, import quotas, exchange control measures, etc., variously separate the price structure of one country from those of others. Thus, the purchasing power parity theory is further limited as a guide to equilibrium exchange rates.
VII. Elasticity of Reciprocal Demand Ignored:
According to Keynes, the purchasing power parity theory fails to take into consideration the impact of elasticity’s of reciprocal demand on the rate of exchange. Changes in the reciprocal demand, as a result of changes in fashion, tastes, level of income, etc., also influence the rate of exchange without changing the price level.
VIII. Capital Movements Ignored:
Keynes also points out that the purchasing power parity theory ignores the influence of capital movements. Capital flows between countries also disturb their rate of exchange.
IX. Transport Costs Ignored:
The theory does not take into account the transport costs of trading commodities between countries. Just as the shipping costs of gold do not allow the market rate of exchange to become equal to the mint parity rate in gold standard, similarly, the transport costs of goods do not allow the market rate to become equal to the purchasing power parity rate in paper standard.
X. Quality of Goods Ignored:
While considering the prices of the same set of goods to estimate the purchasing power of the two countries, the quality of these goods is generally ignored. If the goods of the two countries are not of the same quality, the purchasing power will not be truly comparable.
XI. Invisible Goods Ignored:
The purchasing power parity theory considers only the merchandise trade and ignores the invisible items of the balance of payments. In other words, the theory applies only to current account transactions and neglects the capital account completely.
XII. Effects of Trade Cycle Ignored:
This theory ignores the impact of trade cycle on the exchange rate. As Nurkse writes, “The theory treats demand simply as a function of price, leaving out of account the wide shifts in the aggregate income and expenditure which occur in the business cycle…….. , and which lead to wide fluctuations in the volume and hence the value of foreign trade even if prices or price relationship remain the same.”
XIII. Static Theory:
The theory is static in the sense that it ignores other determinants of exchange rate such as economic relations between nations, incomes and tastes of the people, etc. Even if purchasing power of one currency deteriorates, the balance of trade of that country may actually improve and exchange rate shift in its favour as a result of factors other than price changes.
XIV. Long Period Theory:
The purchasing power parity theory is applicable only in the long period. It does not provide solution to the short run problems of exchange rate and as such is not practical.
The balance of payments theory is the modern and most satisfactory theory of the determination of the exchange rate. It is also called the demand and supply theory of exchange rate.
According to this theory, the rate of exchange in the foreign exchange market is determined by the balance of payments in the sense of demand and supply of foreign exchange in the market. Here the term ‘balance of payments’ is used in the sense of a market balance. If the demand for a country’s currency falls at a given rate of exchange, we can speak of a deficit in its balance of payments.
Similarly, if the demand for a country’s currency rises at a given rate of exchange, we can speak of surplus in its balance of payments. A deficit balance of payments leads to a fall or depreciation in the external value of the country’s currency. A surplus balance of payments leads to an increase or appreciation in the external value of the country’s currency.
According to Ellsworth, “If market forces are allowed to work unimpeded, the demand and supply of foreign exchange establish a rate of exchange that automatically clears the market so that no actual or export payments deficit or surplus can appear.” In the words of Walter, “If the exchange rate is permitted to respond fully to changing supply and demand conditions, the status of the balance of payments of a country tends to determine the value of its currency relative to the currencies of other nations.”
There is a close relation between the balance of payments and the demand and supply of foreign exchange. Balance of payments is a record of international payments made due to various international transactions, such as, imports, exports, investments and other commercial, financial and speculative transactions. The balance of payments includes all payments made by the foreigners to the nationals as well as all payments made by the nationals to the foreigners.
The incoming payments are credits and outgoing payments are debits. The credits in balance of payments or the export items constitute the supply of foreign exchange; the supply of foreign exchange is made by the exporting countries. On the other hand, the debits in the balance of payments or the import items constitute the demand for foreign exchange; the demand for foreign exchange arises from the importing countries.
Any deficit or surplus in the balance of payments causes changes in the demand and supply of foreign exchange and thus leads to fluctuations in the exchange rate. When there is deficit in the balance of payments the debits (or the demand for foreign exchange) will exceed the credits (or the demand for foreign exchange).
As a result, the rate of exchange will rise (or the exchange value of domestic currency in terms of foreign currency will fall). On the other hand, a surplus in the balance of payments means credits (or the supply of foreign exchange), exceeding debits (or the demand for foreign exchange), which in turn, will lead to a fall in the rate of exchange (or a rise in the external value of domestic currency).
The balance of payments theory of exchange rate is graphically represented in Figure 4. D$ and S$ are the demand and supply curves of foreign exchange (i.e., dollars) in India. The demand for foreign exchange curve slopes downwards from left to right indicating that when the exchange rate (i.e., dollar rate of exchange or rupees per dollar) falls, the demand for foreign exchange increases and vice versa.
The supply of foreign exchange curve, on the other hand slopes upwards from left to right indicating that lower the exchange rate (i.e., rupees per dollar), lower the supply of foreign exchange (dollars) and vice versa. Initially, the exchange market is in equilibrium at point E where demand and supply curves (D$ and S$) intersect each other. OR rupees per dollar are the equilibrium rate of exchange and OM is the demand and supply of dollars.
If India has deficit balance of payments with America, i.e., India’s imports from America increase, its demand for foreign exchange (dollars) will increase, shifting the demand curve from D$ to D’$. The new equilibrium is at point E1, which shows a rise in the exchange rate from OR to OR1 rupees per dollar.
Similarly, when India has a surplus balance, its demand for foreign exchange (dollars) decreases from D$ to D”$. The new equilibrium is at point E2 indicating a fall in the exchange rate from OR to OR2 rupees per dollar. In the similar way, it can be shown that changes in supply or in both demand and supply will influence the equilibrium rate of exchange.
The balance of payments theory is superior to other theories on the following grounds:
(i) According to the balance of payments theory, the rate of exchange is determined by the demand and supply of foreign exchange in the market. Thus, the theory is compatible with the general theory of value and regards the problem of the determination of rate of exchange as an integral part of general equilibrium theory.
(ii) The theory recognises the fact that imports and exports of goods alone do not determine the rate of exchange. There are a number of important forces other than the merchandise items which Influence the supply of and demand for foreign exchange and, thereby, the rate of exchange.
(iii) The important implication of the theory is that any disequilibrium in the balance of payments of a country can be corrected by making appropriate adjustments in the rate of exchange, i.e., through devaluation of home currency when there is deficit balance and revaluation of home currency when there is surplus balance.
However, the balance of payments theory has been criticised because of the following drawbacks:
(i) The theory is based on unrealistic assumptions of perfect competition and non-interference of the government in the foreign exchange market. In the present-day world, almost every country has adopted the policy of exchange control.
(ii) The theory assumes that there exists no causal relation between the rate of exchange and the internal price level. But, in reality, there exists a definite relation between the two because the balance of payments position of a country is influenced by the internal cost-price structure of that country.
(iii) The theory is indeterminate in the sense that it does not tell clearly what determines what. According to this theory, the balance of payments determines the rate of exchange. But, it is also equally true that balance of payments itself is a function of the rate of exchange. Thus, it is not clear whether the balance of payments determines the exchange rate or the exchange rate determines the balance of payments.
(iv) The theory unrealistically assumes the balance of payments to be a fixed quantity.
(v) The theory also assumes that the demand for raw materials imported from other countries is perfectly inelastic and is therefore independent of the variations in the price and the exchange rate.
But, this is not true even the demand for most essential commodities has some degree of elasticity. In fact, all the commodities have their substitutes and, thus, are influenced by the price variations caused by changes in the rate of exchange.