Let us make in-depth study of the balance of payments theory of foreign exchange rate in India.
It will be understood from above that the various items in the country’s balance of payments lie at the back of demand for and supply of a foreign currency.
That is why the explanation of determination of foreign exchange rate through demand and supply is also called the Balance of Payments Theory of Foreign Exchange.
The demand for foreign exchange arises from the debit items in the balance of payments, whereas the supply of foreign exchange arises from credit items. The debit items relate to all payments made during a given period by residents of a country to foreigners, and credit items include all payments received during the given period from foreigners by the residents. These payments may be on any account, e.g. goods bought and sold, services rendered and received, capital borrowed or lent, and so on.
By way of illustration, if India has a net debit in its balance of payments, its demand for foreign exchange, say, U.S. dollar, must exceed its supply of U.S. dollar with the result that the rupee price of U.S. dollar will go up or, what comes to the same thing, the external value of the rupee must go down in terms of dollar.
The rupee becomes cheap in terms of dollar. Conversely, a net credit in India’s balance of payments will lead to a fall in the rupee-price of dollar, which means a higher value of the rupee or expensive rupee in terms of US dollar.
When the balance of payments is in deficit, the country will have a weak exchange rate position. There will be increase in the demand for foreign exchange relative to the supply thereof because more payments have to be made than receipt of payments from abroad.
In this case there will be decline in the external value of the domestic currency. But the depreciated external value of its If a country has a surplus on current account, it is said to have a favourable balance of payments. There are more people abroad who have to make payments to this country. The demand for this country’s currency will increase on the part of the holders of foreign currency.
The result will be that the external value of the domestic currency will appreciate. This is how the balance of payments affecting demand for foreign exchange and supply of foreign exchange determines the rate of exchange.
The explanation of foreign exchange through demand or what sometimes is called balance of payments theory of exchange rates is superior because:
(a) It is more realistic as the price of foreign currency is seen here as a function of many significant variables and not merely purchasing power expressed in general price level, and
(b) It clearly shows the possibility of correcting balance of payments disequilibrium through exchange rate adjustment rather than through domestic price deflation as implied by the purchasing power parity.
The chief merit of demand-supply approach to the determination of exchange rate or what is sometimes called balance of payments theory of foreign exchange is that it explains the determination of foreign exchange rate through general demand and supply analysis.
Further, important fact brought out by the theory is that not only exports and imports of goods but also other items in the balance of payments such as invisible items, long-term capital movements also play a significant part in determining demand for and supply of foreign exchange and the equilibrium rate of exchange.
Thus, this theory puts forward more correct explanation of the determination of foreign exchange rate by visualizing foreign exchange as a function of several variables and not just purchasing power representing the general price level. This theory also highlights an important fact that disequilibrium in the balance of payments, if left to the market forces, can be corrected through depreciation or appreciation in exchange rate.