The most satisfactory explanation of fluctuations in the external value of paper currencies is that the free exchange rate tends to be much as to equals the demand for and supply of foreign exchange.
For example, the external value of the inconvertible dollar depends on the demand for and supply of dollars on the foreign exchange market in New York.
The demand for dollars on the New York foreign exchange market comes from people who offer foreign exchange in order to obtain dollar, while the supply of dollars comes from people offering dollars to obtain foreign exchange.
American exporters are an example of the first group, that is, demanders, and American Importers exemplify the second group that is, supplier;. Thus, for example, the demand for dollars by holders of pound sterling constitutes the sterling-supply schedule, and the supply of dollars by those wanting pound sterling constitutes the sterling demand Schedule. In other words, on the New York sterling market the demand for dollars is the same thing as the supply of pound sterling, and the supply of dollars is another way of looking at the demand for pound sterling.
The intersection of the sterling supply curve and the demand curve gives the equilibrium price of sterling that equates that amount of pound sterling offered and the amount of pound sterling demanded. If the equilibrium dollar price of sterling on the New York market happens to be $4 per pound, the equilibrium sterling price of the dollar on the London market tends to be £0.25, which is the reciprocal of $4, or one-forth.
Now the demand for foreign exchange arises from the debit item in the balance of payments, whereas the supply of foreign exchange arises from the credit items. “Debits” here refer to all payments made during a given period by residents to foreigners, and “credit” included all payments made during the period by foreigners to residents.
If for example, the United States has a net debit, its demand for foreign exchange say, pound sterling must exceed its supply of pound sterling, with the result that the dollar price of sterling will go up, what amounts to the same thing, the external value of dollar will go down relative to sterling.
That is to say, dollar becomes cheap in terms of sterling conversely; a net credit in the American balance of payments will lead to a drop in the dollar price of the pound that is to the higher external value of the dollar or the expensive dollar relative to pound. The demand for and supply of foreign exchange is in the final analysis nothing else than the demand for and supply of foreign goods and services; the former is derived from the latter.
If a country has a deficit in its current account as a result of an excess of visible and invisible imports over similar exports, it must experience an adverse balance of payments in the sense that it is paying off the debts by drawing on its foreign exchanges reserves, by exporting gold, or by borrowing on short-term from creditor countries in short, by giving foreigners claims on its currency.
Conversely, a favourable balance of payments means that a surplus country (on current account) must by accumulating claims on foreign currencies. It is not difficult, therefore, to see the relation between the balance of payments and the exchange rate. Since an increase in a country’s claims on another country’s currency means an increase in the supply of that currency on the first country’s foreign exchange market, the domestic price of that currency tends to decrease thus appreciating the external value of the creditor country’s currency.
Suppose, for example, that the United States is accumulating more claims on the rest of the world than the world is on United States. Assume the original exchange rate between the dollar and all foreign currencies to be $4 = £1 (£ representing foreign currencies). Then the supply of foreign exchange on the New York exchange market mu.st increase relative to the demand and the new equilibrium rate of exchange must therefore fall below $4, say to $3.80. This would make the dollar expensive relative to all other currencies and the United States a dear market in which to buy. Eventually, American exports would decline.
This would wipe out a favourable balance of payments in the United States, cheapen the dollar relative to other currencies, and so on, back to equilibrium. Conversely, a deficit country is likely to have a weak exchange-rate position, since an increase in foreign claims on its currency means an increase in the demand for foreign exchange relative to supply to cause a decline in the external value of its currency.
But then the deficit country will be able to wipe out an adverse balance of payments by increasing exports, thanks to the depreciated external value of its currency. Therefore, a deficit country’s position may be weak with respect to the exchange rate but strong with respect to export advantage.
The advantage of the balance-of-payment theory of exchange rates is not difficult to see in the light of the above discussion:
(i) First, the explanation of the determination of exchange rates in terms of supply and demand forces facilitates equilibrium analysis, not to mention its consistency with common sense.
(ii) Second, the theory is more realistic in that the domestic price of a foreign currency is seen as a function of many significant variables, not just purchasing power expressing general price levels.
(ill) But the greatest practical significance of the balance-of- payments theory lies in the fact that it clearly shows the possibility of adjusting balances of payments disequilibria through exchange rate adjustments rather than through internal price deflation or inflation as implied by the parity theory.
The balance-of-payments theory says that the foreign exchange rate is a price which is determined by the demand for and supply of foreign exchange. But the fatal weakness of the balance-of-payments theory as pointed out by inflation school is that it asserts the balance of payments to be a fixed quantity. To use an appropriate metaphor suggested by Keynes, it applies the theory of solids, where that of liquids would be more appropriate. The balance of trade depends on the relation between price levels at home and abroad. In a word, the balance of payments is partially dependent on the exchanges it cannot therefore be used to explain them.