Introduction - 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.
Thus, despite these demerits; the BOP theory is more satisfactory or superior to the PPP theory of exchange rate determination.