Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
 
 
 
 
 
10.3 DETERMINATION OF EXCHANGE RATE IN FREE 
MARKETS 
 
Exchange rate in free market: 
Free exchange rate theory is also known as the Demand 
and Supply theory and the General Equilibrium theory of exchange 
rate or Balance of trade Theory. It holds that the foreign exchange 
rate, under free market conditions, is determined by the conditions 
of demand and supply in the foreign exchange market. Free 
mechanism of trade is applied here. Thus according to this theory, 
the price of a currency (exchange rate) is determined just like the 
price of any commodity is determined by tree play of the forces of 
demand and supply. 
The value of a currency appreciates when the demand for its 
increases and depreciates when the demand fall, in relation to its 
supply in the foreign exchange market. The extent of the demand 
for and supply of a nations currency in the foreign exchange market 
depends on its BOP position. When the BOP is in equilibrium, the 
supply of and demand for the currency are equal. But when there is 
deficit in the BOP, supply of the currency exceeds its demand and 
causes a fall in the external value of the currency; when there is 
surplus, demand exceeds supply and causes a rise in the external 
value of the currency. 
Merits of BOP theory: 
It treats the problem of the determination of rate of 
exchange as an integral part of the general equilibrium 
theory. 
It is in line with the general theory of value. 
This theory explains that any disequilibrium in the balance of 
payments of a country can be corrected through making 
appropriate adjustment in the rate of foreign exchange by 
the way of devaluation. 
It shades lights on various factors affecting the exchange 
rate system. 

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It focuses on demand and supply and facilitates equilibrium 
analysis.