The theory of demand and supply is considered the most suitable for the determination of rate of exchange, under inconvertible paper money standard in a free market.
Definition :-
In a free market the rate of exchange between countries having inconvertible paper money standard will be determined by the demand for and supply of a country currency. In other words the external value of the currency in terms of foreign currencies depends upon demand for and supply of it.
Determinants Of Demand :-
If the export of an any country increases, its currency demand also increase. For example India increases the exports of the various commodities to U.K, USA and France. Now these three countries will purchase the Indian currency at a given rate of exchange to make the payment to India. So the demand of Indian currency will increase. The demand of the currency depends upon the following items,
1. Export of goods and services.
2. Capital receipts.
3. Unrequited receipts.
Determination Of Supply :-
Supply of country's currency is the amount of its currency which it offers for sale at given rate of exchange. Supply of currency depends on house country, imports. If imports value is greater than exports value, balance of payment will be also unfavorable.
Following are main items which determine the supply of currency.
1. Import of goods and services.
2. Unrequited payments.
3. Capital payments.
DETERMINATION OF RATE OF EXCHANGE :-
An equilibrium rate of exchange will be at that point when he value of total exports ( goods and services ) are equal to the value of total imports. We can also explain it by simple diagram
According to the diagram DD curve shows demand for SS shows the supply of country's currency. Both the curves intersect each other at the point K. So the rate of exchange will be OL. On this rate of exchange OM quantity of currency will be traded.
Changes In Exports :-
If exports increases then demand for the currency will increase and external value of the currency will also rise.
Changes In Imports :-
If the imports of any country increases, it will lower the external value of the currency, on the other hand if imports falls and exports remains constant then the external value of currency will rise.
Comparison :-
On the following grounds we can say that this theory is more better than the previous theory.
1. Balance Of Payment Adjustment :-
This theory shows that disequilibrium in the balance of payment can be removed by adjusting the rate of exchange. While in the old theory it was stated that through domestic price deflation balance of payment can be adjusted.
2. Considers Other Factors Also :-
The modified theory takes in to account all factors which influence the demand & sup[ply of foreign exchange, including the price level.
3. Equipment Analysis :-
This theory also facilitates the equilibrium analysis. So it is very useful for the determination of rate of exchange.
Inspite of these advantages this theory ignores many items entering in international transaction. Sometimes to stable the currency value, the currency can be bought from those markets where it is cheap and can be sold to other markets.
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