Several theories have been propounded as to how the rate of exchange is determined between different currencies. Among these, the four more important theories are as follows:

1.    Trade of Elsticisties Approach
2.    Purchasing-Power Parity Theory
3.    Monetary Approach
4.    Portfolio-Balance Approach.

1.    Trade or Elaticities Approach. This approach postulates that the equilibrium exchange rate is the one that balances the value of the antion’s imports and exports.

If a nation is faced with a trade deficit, domestic currency will depreciate. This makes the nation’s exports cheaper to foreigners and imports more expensive to domestic residents. The result is that the nation’s exports rise and imports fall until trade is balanced.

Since the speed of adjustment depends on how elastic exports and imports are to exchange rate changes, this approach is referred to as the elasticity approach.

2.    Purchasing-Power Parity Theory. The 3Ps theory simply states that the exchange rate between two currencies is simply the ratio of the two countries’ general price levels. For example, if a basket of commodities can be purchased for Rs. 100 in New Delhi and for $2 in New York, the rate of exchange between rupee and dollar should be $ 2 = Rs. 100, i.e., $1 Rs. 50.

If the relative prices change, the rate of eexchange will also change. Suppose the same basket begins to cost Rs. 180 in New Delhi and $3 in New York, the new rate f exchange will be
$1 = Rs. 60.

3.    Monetary Approach. This approach postulates that exchange rates are determined in the process of equilibrating or balancing the total demand and supply of the national currency in each nation.
4.    Portfolio-Balance Approach. This approach postulates that exchange rates are determined in the process of balancing the demand and supply of financial assets in each country. An increase in the home coutnry’s money supply leads to an immediate decline in the interest rate in the nation and to a shift from domestic bonds to the domestic currency and foreign bonds. The shift to foreign bonds causes an immediate depreciation of the home currency. Over time, this depreciation stimulates the nation’s exports and discourages its imports. This leads to a trade surplus and appreciation of the domestic currency, which neutralized part of its original depreciation.

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