Three important thoeries for the exchange rate determination are:
1. Mint Parity Theory (Gold Standard)
2. Purchasing Power Parity PPP Theory
3. Balance of Payments (BOP) Theory
1. Mint Parity Theory (Gold Standard): However, the gold standard had collapsed during the First World War (1914 - 1918). Under the mint parity the exchange rate was determined on a weight-to-weight basis of the two currencies. However, after the break-down of the gold standard, there was confusion in determination of the exchange rate. Gustav Cassel a Swedish economist enunciated the theory of determination of the equilibrium exchange rate which was based in the parity between two currencies of the countries.
2. Purchasing Power Parity PPP Theory
The first original reference of PPP Theory was made by David Ricardo. However, Gustav Cassel popularized this theory in 1918. According to PPP theory, when exchange rates are of a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations.
Foreign currency is demanded by the people because it has some purchasing power in its own nation. Also domestic currency has a certain purchasing power, because it can buy some amount of goods/services in the domestic economy. Thus, when home currency is exchanged for any foreign currency, in fact the domestic purchasing is being exchanged for the purchasing power, because it can buy some amount of goods/ services in the domestic economy. Thus, when home currency is exchanged for any foreign currency, in fact the domestic purchasing power is being exchanged for the purchasing power of that foreign currency. This exchange of the purchasing power takes place at some specified rare where purchasing of two currencies nations gets equalized. Thus, the relative purchasing power of the two currencies determines the exchange rate. The exchange rate under this theory is in equilibrium when their domestic purchasing powers at that rate of exchanges are equivalent e.g., Suppose certain bundle of goods/ services in U.S.A. costs U.S. $ 10 and the same bundle in India costs, Rs. 450/- then the exchange rate between Indian Rupee and U.S. Dollar is $1 = Rs. 45. Because this is the exchange rate at which the parity between the purchasing power of two nations is maintained. A change in the purchasing power of any currency will reflect in the exchange rates also. Hence under this theory the external value of the currency depends on the domestic purchasing power of that currency relative to that of another currency.
Gustav Cassel has presented the PPP theory in two versions.
A) Absolute Version of the PPP Theory
According to the absolute version of the purchasing power parity (PPP) theory, the exchange rates between two currencies should reflect the relation between the international purchasng powers of various currencies. In simple words the exchange rate would be determined, at the point where the internal purchasing power of the respective currencies gets equalized. Let us take an example to illustrate the point. Suppose particular basket of goods cost Rs. 1000/- in India and $ 100 in the U.S.A. That means the exchanges rate would be Rs. 10 = $1.
The exchange rate an be determined with the following equation.
In this equation 'P' i.e. prices are related to the respective bundle of goods with same weights assigned in both the countries. Thus, the above equation explains that the equilibrium exchange rate is determined by the ratio of the internal purchasing power of foreign currency and domestic currency in their own countries. Thus, to conclude the absolute version of this theory maintains the the absolute version of this theory maintains that the absolute purchasing power of respective currencies does play a vital role in determining the equilibrium exchange rate.
B) Relative Version of the PPP Theory
The relative version was put forward by Cassel in order to find the strength of the changes in the equilibrium exchange rate. Any departure from the equilibrium will lead to the disequilibrium. It can take place due to changes in the internal purchasing power of a particular currency. The changes in the purchasing power are measured with the help of domestic price indices if the respective nation. We need to assume any past rate of exchange as a base exchange rate in order to know the percentage change in the exchange rate. If we compare the price indices in the past i.e. base period with that of the present period, the new equilibrium exchange rate could be found out.
It can be simplified with the following equation.
Thus, according to the equation when the price level in concerned nation changes, automatically the internal purchasing power of the currency of that nation goes on changing. This change leads to the change in the equilibrium exchange rate. Thus, under this theory Gustav Cassel has tried to link the purchasing power of two currencies in determining the equilibrium exchange rate. However, it has been criticized on the following grounds.
Criticism of Purchasing Power Parity (PPP) Theory
A) Limitations of the Price Index: As seen above in the relative version the PPP theory uses the price index in order to measure the changes in the equilibrium rate of exchange. However, price indices suffer from various limitations and thus theory too.
B) Neglect of the Demand / Supply approach: The theory fails to explain the demand for as well as the supply of foreign exchange. The PPP theory proves to be unsatisfactory due to this negligence. Because in actual practice the exchange rate is determined according to the market forces such as the demand for and supply of foreign currency.
C) Unrealistic Approach: Since the PPP theory uses price indices which itself proves to be unrealistic. The reason for this is that the quality of goods and services included in the indices differs from nation to nation. Thus, any comparison without due significance for the quality proves to be unrealistic.
D) Unrealistic Assumptions: It is yet another valid criticism that the PPP theory is based on the unrealistic assumptions such as absence of transport cost. Also it wrongly assumes that there is an absence of any barriers to the international trade.
E) Neglects Impact of International Capital Flow: The PPP theory neglects the impact of the international capital movements on the foreign exchange market. International capital flows may cause fluctuations in the existing exchange rate.
F) Rare Occurrence: According to critics, the PPP theory is in contrast to the Practical approach. Because, the rate of exchange between any two currencies based on the domestic price ratios is a very rare occurrence.
Thus, the PPP theory is criticized on the above grounds.
Conclusion On Purchasing Power Parity Theory
Despite these criticisms the theory focuses on the following major points.
It tries to establish relationship between domestic price level and the exchange rates.
The theory explains the nature of trade as well as considers the BOP (Balance of Payments) of a nation.
Thus, Gustav cassell's attempt to explain the exchange rate determination based on domestic price indices was very unique attempt.
3. Balance of Payments (BOP) Theory
BOP is yet another important theory of exchange rate determination. It is also known as General Equilibrium Theory.
According to this theory, when there is free market situation, the exchange rates are determined by the market forces i.e. demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined.
Under this theory the external values cf domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However, under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises, i.e. exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations.
The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market farces determines the value of the commodity.
According to this theory the BOP disequilibrium can be corrected by adjusting the exchange rate in either direction i.e. devaluation or revaluation. However, this theory has a drawback like it ignores the impact of exchange rate on the BOP.
Methods Used To Determine Exchange Rates
Read comprehensive tutorial on Charles Sturt Univeristy's Website to understand which methods are used to determine exchange rates.
Limitations or Demerits of BOP Theory
Although BOP theory is superior to the PPP theory, still it is not free from demerits. The BOP theory is based on the unrealistic assumption such as perfect competition in foreign exchange market. Also BOP theory ignores the link between domestic price level and exchange rate determination. The BOP positions on exchange rate however the exchange rate can also influence the BOP position.
Final Conclusion
Thus, despite these demerits; the BOP theory is more satisfactory or superior to the PPP theory of exchange rate determination.
