The balance of payments theory states that the rate of exchange is determined by the forces of demand and supply for the currency in the foreign exchange market. The external value of money is, thus, independent of the level of domestic price level. The demand and supply for the currency may arise out of many items. Some items like import of certain essential raw materials may be perfectly price inelastic and therefore insensible to the change in exchange rates. Some items, like payments of interest on foreign loans, are autonomous and they exert influence on exchange rates.
Similarly, supply of money consists of exports and many autonomous items. When the balance of payments is at deficit, it indicates that the supply of foreign exchange is less than demand. Therefore, in relation to the domestic currency the price of foreign currency will rise. In other words, the domestic currency will depreciate. When the balance of payments position is at surplus, it indicates that the supply of foreign exchange is in excess of the demand.
Therefore, in relation to the domestic currency the price of foreign currency will fall. Or, the domestic currency will appreciate. The theory considers all items in the balance of payments which influence the supply of and demand for foreign exchange and hence the rate of exchange.
Thus, this is an improvement over the purchasing power parity theory and the mint par theory. This theory also suggests that an adverse balance of payments position can be corrected by marginal adjustment in the exchange rates, i.e., by devaluation or evaluation. But it is said that the balance of payments does not influence the rate of exchange, but is influenced by it.
