Balance of Payments Theory:

The balance of payments theory, also known as the Demand and Supply Theory and the General Equilibrium Theory of exchange rate, holds that the foreign exchange rate, under
free market conditions, is determined by the conditions of demand and supply in the foreign exchange market. Thus, according to this theory, the price of a currency i.e. the
exchange rate, is determined just like the price of any commodity is determined by the free play of the forces of demand and supply.

The value of a currency appreciates when the demand for it increases and depreciates when the demand falls, in relation to its supply in the foreign exchange market. The extent of the demand for and supply of a country’s currency in the foreign exchange
market depends on its balance of payments position. When the balance of payments is in equilibrium, the supply of and demand for the currency are equal. But when there is a deficit in the balance of payments, supply of the currency exceeds its demand and causes a fall in the external value of the currency; when there is a surplus, demand exceeds supply and causes a rise in the external value of the currency.

Evaluation of the Theory: The balance of payments theory provides a fairly satisfactory explanation of the determination of the rate of exchange. This theory has the following
merits.

Unlike the purchasing power parity theory, the balance of payments theory recognizes the importance of all the items in the balance of payments, in determining the exchange rate.

This demand and supply theory is In conformity with the general theory of value- like the price of any commodity in a free market, the rate of exchange is determined by the forces of demand and supply.

This theory brings the determination of the rate of exchange within the purview of the General Equilibrium Theory. That is why this theory is also called the general equilibrium theory of exchange rate determination.

It also indicates that balance of payments disequilibrium can be corrected by adjustments is the exchange rate (i.e. by devaluation or revaluation), rather than by internal deflation or inflation.

The main defect of the theory is that it does not recognize the fact that the rate of exchange may influence the balance of payments.