Can You Explain Balance Of Payments Theory Of Exchange Rate?

The balance of payments theory of exchange rate is also named as general equilibrium theory of exchange rate. According to this theory, the exchange rate of the currency of a country depends upon the demand for and supply of foreign exchange. If the demand for foreign exchange is higher than its supply, the price of foreign currency will go up. In case, the demand of foreign exchange is lesser than its supply, the price of foreign exchange will decline.

The demand for foreign exchange and supply of foreign exchange arises from the debit and credit items respectively in the balance of payments. The demand for foreign exchange comes from the debit side of balance of payments. The debit items in the balance of payments are import of goods and services and loans and investments made abroad.


The supply of foreign exchange arises from the credit side of the balance of payments. It is made up of the exports of goods and services and capital receipts. If the balance of payments of a country is unfavourable, the rate of foreign exchange declines. On the other hand, if the balance of payments is favourable, the rate of exchange will go up. The domestic currency can purchase more amounts of foreign currencies.

Balance of payment theory of exchange rate means that the expected revenue is equal to projected expenditure in a given year.