The Theory of Elasticity Explained
A theory concerning the determination of the exchange rate is the so called theory of elasticities. According to it, the price of the foreign exchange that keeps the balance of payments in equilibrium is the actual exchange rate.
The elasticity of demand to a change in price determines the degree of response of the exchange rate to a change in the trade balance. This means that a weak trade balance is observed when a country experiences high levels of imports.
As a result, an increase in the exchange rate is observed, which in turn leads to an increase in the exports of the country. The domestic income will be increased as a result of this, which will be accompanied with a fall in the levels of the foreign income.
The increase in the domestic income in a particular country leads to an increase in domestic consumption of domestically produced goods and services as well as foreign ones. This will eventually lead to an increase in the demand for foreign currencies and a decrease in the foreign income, the one in the country counterparty.
Since the income in this country will fall, the domestic consumption of the both domestically produced and foreign goods and services will decrease. This will result in a decrease in the value of the domestic currency, which will be caused by the less demand.
The elasticities approach has its drawbacks. One of the problems with this theory is that over the short term the exchange rate is more inelastic than over the long term.
Additionally, different exchange rate variables appear that change the movement of the exchange rate.