Theories of Foreign Exchange

After decades of relative neglect, economic theory, especially in its mathematical form, has taken a new life since the end of World War II.

The renaissance has included many aspects of international economics, but theories that purport to explain the levels and movements of parities and spot and forward exchange have been somewhat neglected. The result is that parities, spot and forward exchange are still a subject of research and controversy.

In its simplest form, the purchasing power parity theory affirms that the rate of exchange establishes itself at a point that will equalize the prices in any two countries. One of the functions of the rate of exchange, according to this theory, is to equalize the purchasing power of the several currencies.

A rate of exchange that does nothing more than equalize price levels will not necessarily prove to be an equilibrium rate. Foreign trade usually includes capital and unilateral transfer movements, and the purchasing power parity theory does not pretend to even out with them.

Adding together, nations produce many commodities that do not enter into international trade, and the prices of those domestic goods obviously cannot be equalized internationally. Furthermore, studies of European prices and exchange rates during inflationary periods of indicate that internal price levels are frequently determined by rates of exchange, and not the other way around.

The purchasing power parity rate of exchange does have the signal advantage, however, of being relatively determinable, whereas some theories do not provide a practical method of calculating an exchange rate or a par value. Also, since the merchandise trade is the most important element of world commercial relations, the theory does have at least limited applicability. For such reasons as these, it continues to have considerable acceptance as a workable approach to the general movement of exchange rates.

The balance of payments or the equilibrium theory of exchange rates affirms that the exchange rates tend to establish itself where it will maintain balance of payments equilibrium and eliminate surpluses and deficits. The theory might be valid if the exchange rates were allowed to float freely and attain their market, or equilibrium levels. Under the Bretton Woods system, however, limits are set to the fluctuations of exchange rates and government intervention in the exchange markets impedes the free movement of rates. Hence, the theory is more a statement of a tendency than a complete explanation.

The supply and demand theory, according to this one, the exchange rate is held to be determined by the supply and demand for foreign currencies. Actually, the supply and demand theory is not a theory, but instead a descriptive mechanism.

To say that a rate of exchange is established by supply and demand is to tell how a rate is established, but to say a little about the factors that determine it or why the rate is at a given level and not at some other level. All of the forces, substantive, technical, and psychological, that have impact on a rate of exchange, must, by the very nature of the market itself, act by determining the demand for, and the supply of foreign exchange.

The psychological theory--- the exchange rate is largely conditioned by the attitudes of those who deal in it. If, in their opinion, a rate is below its correct level or will rise in the future, they are inclined to but it; they thereby increase the demand for currency and work to raise its rate. If, on the other hand, they feel that the rate overvalues the currency or is likely to decline, they are apt to sell their holdings and thereby increase the market supply of the currency and push its rate down.

Lastly, the interest parity theory is the most widely accepted explanation of the magnitudes of forward exchange rates. it is based on the fact that short-term interest rates differ from country to country and also the fact that banks, which buy or sell foreign currencies forward, usually like to cover their positions by the purchase or sale of these currencies spot.