Three different theories have been evolved to explain the rate of exchange between currencies of different countries. They are: (i) Mint Par Theory, (ii) Purchasing Power Parity Theory, and (iii) Balance of Payments Theory.
Mint Par Theory. This theory is valid where the countries are on gold standard. Under the gold standard, the value of currency is fixed as the value of the gold of a definite weight and fineness. The monetary authorities undertake to purchase or sell gold in unlimited quantities at a fixed price to keep the price of gold stable. When two countries are on gold standard, the rate of exchange between these two countries is determined on the basis of the relative gold content of each currency.
For example, if the gold content of Indian rupee is 5 grains of standard purity and that of US dollar is 40 grains of standard purity, the rate of exchange between Indian rupee and US dollar can be determined as under:
1 Rupee = 5 /40 = US $ 0.125
or, 1 US $ = 40/5 = Rs. 8.
This rate of exchange is known as the mint par of exchange because at the Indian mint one rupee will get 5 grains of gold and in the USA US $ 0.125 will get the same quantity of 5 grains of gold.
The actual rate of exchange in the market may differ from the mint par rate within a well-defined limit. The limit is determined by the cost of export of gold. For example, let us suppose, an Indian importer has to make payment of US $ 10,000 to the exporter in USA. The Indian importer has two alternatives. He can purchase gold and export it to USA. But this would involve cost in the form of packing, freight and insurance charges. The other alternative is to buy from a bank a credit instrument in US dollars. He would adopt the second alternative so long as the market value (bank’s rate of exchange) is less than the mint par value plus the cost of exporting the gold.
For example, if the cost of exporting gold amounts to 25 paise per US dollar, he would prefer purchasing US dollars instead of exporting gold so long the market rate does not exceed Rs. 8.25 per US dollar. If the market rate exceeds Rs. 8.25 it would be advantageous for him to export gold. Therefore, at any time the market value cannot exceed Rs. 8.25.
Similarly, when an exporter has to receive payment from the USA he has the alternative of either importing gold from the USA or getting the amount in US dollars and selling the dollars locally. If he imports gold he has to incur the cost of freight and insurance, etc. Assuming the cost to be 25 paise per US dollar, he would prefer to receive US dollars and sell it to the market so long as the loss does not exceed this amount. Therefore, the market selling rate at any time cannot be worse than Rs. 7.75 per US dollar.
Thus, the market rate has to fluctuate between Rs. 8.25 and Rs. 7.75 per US dollar. This maximum and minimum limit within which the rate would fluctuate is known as specie points or gold points. As said at the outset, the mint per theory is valid only where the countries are on gold standard. With the abolition of gold standard this theory has lost much of its significance.
