Flow Theory (Exchange Rate Determination Theory)

Saturday, September 12, 2009

The flow theory of the exchange rate is the proposition that the exchange rate adjusts to make the flow supply of the dollars equal to the flow demand for dollars. The flow supply of dollars in any given period depends on the value of US imports. U.S. Residents supply dollars in exchange for foreign currency in order to be buy foreign imports. The flow demand for dollars in any given period depends on the value of US goods (export)that foriegners plans to buy during that period of time. In addition to the flow demand and supply resulting from imports and exports, there is also a net flow demand or supply resulting from imports and exports, there is also a net flow demand or supply resulting from international borrowing and lending. According to the flow theory of the exchange rate the value of exchange rate adjusts to keep the flow demand for a currency equal to its flow supply.