The following article will guide you to learn about how is the rate of exchange between two currencies determined.

Foreign Exchange Rates:

Thus exports and imports of goods between nations with different units of currency introduce a new economic factor: the foreign exchange rate, which gives the price of the foreign currency in terms of domestic currency.

The two important questions are:

(1) What are the economic principles that determine foreign exchange rates?


(2) What are the factors that underlie exchange rate movements?

There are two main types of foreign exchange system:

(i) The fixed exchange rate system as under gold standard and

(ii) The floating (or flexible) exchange rate system as under inconvertible paper currency sys­tem.


We may start with the gold standard:

A. The Working of Gold Standard:

Under full gold standard each monetary unit consists of a fixed amount (weight) of gold. The price of gold Sore in terms of the national currency is fixed. In addition there is no restriction on export and import of gold. Under this system the exchange rate remains fixed and stable and adjustments in exchange rates are brought about by export and import of gold. Thus, the value of a country s currency remains fixed in terms of gold.

The essential rules of the gold standard which must be observed by all the central monetary authorities which are wishing to operate successfully an international monetary standard are three in number:

1. The monetary authority (i.e., the central bank) of each country must take steps to fix the gold value of its own national currency.


2. There must be free import and export of gold into, and out of, each country which is having the gold standard system.

3. Finally, each central bank must make arrangements for the domestic supply of its own money such that the supplies of that money go up in a more or less automatic manner when there is a persistent inflow of gold into the country, and such that they go down in a more or less automatic manner when there is a persistent export of gold out of the country.

If two countries, A and B, both fix the value of their currencies in terms gold and if there is a free import and export of gold in both countries the value A’s currency (say, the dollar) will, within narrow limits, be fixed in terms of B’s currency (say, the pound).

Now if it costs 5 cents to send $4 worth of gold from A to B it will pay anyone in A who has a payment to make in B to give anything up to $4 05 notes directly for £1 note rather than to ship gold to B. But if he has to give more than $4.05 for £1, it will pay him rather to ship gold to B. For this reason $4.05 to £1 is called A’s gold-export point and B’s gold-import point.

Thus, the pound can appreciate in value in the foreign-exchange market from its par value of $4.0 to £1 up to $4.05 for £1, or depreciate down to $3 95 for £1. Outside these narrow limits there will be no variation in the exchange rate but gold will flow to remove any deficit or surplus in the balance of payments.

P.A. Samuelson, “So, except for the low costs of melting down, shipping across the ocean, and re-coining, all countries on the gold standard had stable exchange rates whose par values, or parities, were determined by the gold content of their money unit.”

The Adjustment Mechanism:

The adjustment mechanism under the gold standard is simple enough. It was worked out in detail by David Hume It is known as the price-specie-flow-mechanism (or Hume mechanism).

The mechanism is summarised below:


Suppose country A imports too much and begins to lose gold. This loss of gold reduces its price and cost level, thereby (1) decreasing its imports of foreign goods that have become relatively dear, and (2) increasing exports of its relatively cheap home-produced goods. The other country B is at first having a so-called ‘favourable balance of trade’—as it sends more goods abroad than it imports, receiving gold in exchange. Now its price and cost levels of goods will rise as suggested by the Quantity Theory of Money. This is the third reason (3) for its now-ex­pensive exports to go down in physical amount and (4) for its imports of the first country’s now-cheapened goods to rise.

In the word of Samuelson, “The result of this four-step gold flow price level mechanism is (normally) to improve the balance of payments of the country losing gold and worsen that of the country with the favourable trade balance—until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow. The equilibrium is stable and self-correcting, requiring no tariffs and other state action”.

Having seen how the adjustment process works itself out under an idealised stable gold standard we may analyse the role of supply and demand forces in bringing about the necessary balance of payments adjust­ment under inconvertible paper currency system.

B. Exchange Rate Determination Under Paper Currency System:

As for exchange rate determination under paper currency system there are two theories:


(1) The purchasing power parity theory and

(2) The supply-demand theory.

These two theories may now be discussed:

1. The Purchasing Power Parity Theory:


The classical economist like David Hume understood long ago that tire value of money would everywhere be the same; with free trade and a metallic standard, the rate of exchange between two currencies depends solely on their respective purchasing power over identical exportable goods. Thus he suggested that an equilibrium rate of exchange is to found at the quotient between the price levels of different countries. This is the essence of the purchasing power parity theory.

The purchasing power parity theory tells us that the rate of exchange between any two currencies tends to reflect their relative purchasing power. This theory is based on a law, called the law of one price (LOOP) which simply states that the price of an internationally traded goods will be the same throughout the world when expressed in one currency. Thus, if a basket of goods cost £100 in London and $240 in New York, then the rate of exchange between the British pound and the US dollar should be $2.40=£1. This is the purchasing power parity rate.

This theory has provided a clue to the equilibrium level of a flexible exchange rate in relative behaviour of the price levels in two countries.

As Samuelson says: “Let America and Europe be at equilibrium, say, at $2 00 per £1 Now let America double all her prices by increasing money supply (MV and let Europe keep her M limited enough to produce a steady price level. Then two other things equal (such as employment remaining Ml and there being no innovations, crop failures, tariffs or change in tastes), the new demand and supply interaction will come at twice the old $2.40 rate namely, at $4.80 per £1 with the dollar depreciating by as much as its price level rises”.

The Rationale:

The underlying logic is simple enough. If all wages and prices are doubled in the crude quantity equation through an exact doubling 55 money supply, one can buy exactly the same quantity of imports and sell the same volume of exports at the new exchange rate which has doubled like price, wages and money supply. It is, as if, one old dollar is equivalent to two new dollars.


According to the purchasing power party theory “the equilibrium rate of exchange between two currencies is such as gives equality in their purchasing power”. In short, the process of exchange rate adjustment due to differential changes in price levels operates continuously when two nations experience different rates of inflation. The rise in the general price level of American goods relative to British goods causes a depreciation of the dollar relative to the pound in the foreign exchange market.

When the general price level in the USA rises relative to that in Britain British goods become less expensive relative to American goods. Hence, at the initial exchange rate of $2.40=£1 American demand for British imports increases while British citizens reduce their demand for American goods. The demand for pounds therefore shifts to the right (from DD to D’D’) while the supply curve for pounds shifts leftward from SS to S’S’ as in Fig. 1.

The Cassel Mechanism

The resulting excess demand for pounds (equal to the distance between points a and b) causes the exchange rate to rise to $3.60 per pound. The depreciation of the dollar relative to the pound cuts back the American demand for British goods and increases Brit­ish demand for American goods.

It follows, therefore, that if two nations are each experiencing the same rate of inflation, the relation between their general price levels re­mains the same. The ex­change rate between their currencies will therefore remain unchanged, all other things remaining the same.

However, if a nation’s rate of inflation is greater than that of a trading partner, the nation will reach the higher inflation rate and will experience an increase in its exchange rate — a depreciation of its currency — all other things remaining the same.


Two versions:

The theory has two versions — an absolute and a relative. The absolute version deals with the determination of the rate at a given time period. The ‘absolute’ version is based on the assumption that prices of goods should be equalised by trade everywhere in the world. Where goods cost more in A than in B, when A’s currency is overvalued by the percentage of the higher cost.

The relative version deals with movements in the rate caused by movements of price-levels relative to some earlier time period Since the value of a currency cannot be defined except in a relative sense it is the relative version which is significant, or, simply,

$/£ = Purchasing power of $/Purchasing power of £

= Price level in the UK/Price level in the USA

since the purchasing power varies inversely with the price level.



The purchasing power parity doctrine has been criticised on the following grounds:

1. Firstly in its absolute form, the doctrine is a truism as the crude quantity theory of money, if one assumes free movement of goods from one country to another. It just suggests that different rates of inflation in the two countries cause the exchange rate to change.

2. Secondly, the theory breaks down completely when there exists vari­ous restrictions on trade like tariffs and quotas, transport costs, exchange control, multiple exchange rates, etc. Under such situations the exchange rate hardly reflects the domestic purchasing power since an import price is the sum-total of supply price of a foreign country plus the tariff imposed by the importing country.

Says R.N. Waud: “Given a sufficient length of time the exchange rate between the nations’ currencies will tend to adjust Reflect changes in their price levels, all other things remaining the same. Of course, all other things do not remain unchanged in reality”. Hence it is usually difficult to find real-world adjustments that are as simple as our hypothetical example suggests.

3. Thirdly it rules out the existence of non-traded goods such as house­hold haircuts, construction activities, etc. that do not enter into international trade. But such goods do exert considerable influence on the domestic price level.


4. Fourthly, it is applicable only to commodity trade which is only a part of balance of payments. It excludes capital transactions between countries which is also an important item of a country’s external transactions.

5. Fifthly, it ignores the structural changes to which occur in an economy from time to tune. In fact, due to fundamental changes in the structure of trade between two countries, changes in national income and changes in tariffs or import controls over a period of time, the theory loses its relevance

6. Finally, the necessity of using price indices introduces all the defects of index numbers. Thus, using price indices is a very imperfect means of calculating the equilibrium exchange rate between two currencies.


Nevertheless, the theory can be used on a selective basis. In fact, much of the discredit under which the theory has fallen arises from its improper use. Moreover, for general price-level movements due to inflation (as during a war) the theory has quite some relevance.