Different Theories of Exchange Rate Determination

Different Theories of Exchange Rate Determination

Different Theories

Trading has been in the world for a long time and has been creating waves in the global economy to such a great extent that it has become an indispensable part of the structure. With people from many countries indulging in trading opportunities, there always remains a scope for the theories to be researched more. Life is nothing without money, and this realization drives people to strive for more. The par values of different currencies can be determined to help in making the right trading decisions. The exchange rate is one factor that plays a crucial role in the whole setup of an economic system. Alternative theoretical explanations have been devised to determine the value of these currencies, and some of them have been accepted to be the most prominent ones. Let us look at a few of them in detail.

1.      The Mint Parity Theory

All countries with the same metallic standard were categorized and studied under the earliest theory of foreign exchange known as the mint parity theory. The countries with gold as the standard currency could use it as their unit value to freely convert the assets into gold. The weight of gold was the value of the currency unit under which the standard of the metal was defined. Buying and selling of gold were allowed up to an unlimited extent by the country’s central bank. The price of conversion of the standard currency into gold was known as mint price. Free international flows of gold were used to adjust the balance of payments under the gold standard.

2.      The Purchasing Power Parity Theory

The exchange rate between two inconvertible paper currencies is determined in the purchasing power parity theory. Swedish economist Gustav Cassel is responsible for the existence of this powerful theory. According to this theory, the equality of the purchasing power of two inconvertible currencies determines the equilibrium rate of exchange. The theory also implies that the two countries’ internal price level influences the exchange rate between the currencies. The two versions of the purchasing power parity theory are the absolute version and the relative version. General price level, issues with the price index numbers, neglect of capital account, and a convenient assumption of BOP equilibrium have led to economists’ severe criticism about the theory’s applications.

 

3.      The Balance of Payments Theory

Factors autonomous of internal money supply and price level determine the exchange rate of a currency that maintains that value with the other country. The theory focuses on various aspects of foreign exchange, and it states that the balance of payments position of a country influences the exchange rate. The excess in supply of foreign currency is indicated by the balance of payments surplus. Such situations can lead to an appreciation of the home currency but the depreciation of the foreign counterpart. It is always the supply of goods and services from one country to another that determines the supply of foreign exchange.

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