(i) Merits:
i. It provides an explanation of the determination of demand and supply schedules of a currency in the foreign exchange market. For this reason, it is better than those theories which ignore this explanation.
ii. The theory “is more realistic in the sense that the domestic price of a foreign currency is seen as a function of many significant variables, not just its purchasing power expressing general price levels.”‘
iii. The theory can be extended to incorporate the fact that balance of payments of a country is influenced by several factors, and may also be adjusted through various policy measures.
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iv. The theory is able to accommodate unilateral capital movements irrespective of their nature, duration and magnitude.
Thus, it explicitly recognises the fact that rate of exchange is subject to diverse pressures, including for example, war reparations, servicing of outstanding foreign debts, speculative flights of capital and so on.
(ii) Demerits:
i. The theory, by itself, does not explain the entire field of forces which determine the flow of payments across countries and, thereby, influence exchange rates.
ii. It appears to take the position that there is a one-sided cause-effect relationship between balance of payments and rate of exchange.
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It says that the balance of payments position of a country explains the sophisticated notion of equilibrium rate of exchange.
It ignores the fact that exchange rate and balance of payments are inter-dependent and that their cause-effect relationship can run from the direction of exchange rate variations to balance of payments, as well.
According to one opinion, “Balance or imbalance in a country’s external transactions, far from one-sidedly determining exchange rate, is largely a consequence of the relation between the exchange rate and relative price level.”‘
iii. As a theory of exchange rate determination, it does not help us in working out the equilibrium rate of exchange on a priori basis.
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On the other hand, a country may experience temporary and cyclical fluctuations in its balance of payments which may be absorbed through a variation in its gold and foreign exchange reserves rather than changes in exchange rate itself.
“The doctrine vaguely defines the equilibrium rate of exchange as one which, if fixed for at least several years”, would not cause chronic surplus or deficit in the balance of a country.
“But it does not tell us how to calculate the rate even approximately, nor even set forth the general principles determining it.”