There are two important theories which explain the determination of exchange rate viz.,
The Purchasing Power Parity Theory (PPP)
The Balance of Payment Theory.
(1) The Purchasing Power Parity Theory: The purchasing power parity theory was advocated by the Swedish Economist Gustav Cassel. According to this theory, equilibrium exchange rate between two inconvertible paper currencies is determined by the equality of their purchasing power. In other words, the rate of exchange between two countries is determined by their relative price levels.
According to the theory, the exchange rate between two countries is determined at a point which expresses the equality between the respective purchasing powers of the two currencies. This is the purchasing power parity which is a moving par and not a fixed par as under the gold standard. Thus with every change in the price level, the exchange rate, also changes. To calculate the new equilibrium exchange rate, the following formula is used:
R = Domestic price of foreign currency x Domestic price index/Foreign price Index
(2) Balance of payments theory: According to this theory, the foreign exchange rate, under free market conditions, is determined by the conditions of demand and supply in the foreign exchange market. Under free exchange rates, the exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an unfavourable balance of payments reduces the exchange rate. Thus the theory implies that the exchange rate is determined by the demand for and supply of foreign exchange.
When the balance of payments is in equilibrium, the supply of and demand for the currency are equal. If the exchange rate falls below the equilibrium exchange rate in a situation of adverse balance of payments, exports increase and the adverse balance of payments is eliminated and the equilibrium exchange rate is reestablished.
Under a favourable balance of payment situation, the exchange rate rises above the equilibrium exchange rate, exports decline, the favourable balance of payments disappears and the equilibrium exchange rate is re-established. Thus at any point of time, the rate of exchange is determined by the demand for and supply of foreign exchange as represented by the debit and credit side of the balance of payments.
