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There are many reasons why exchange rates change. There are also many theories which explain why exchange rate change. One of these theories is "Balance of Payment Theory of Exchange Rates". BOP theory suggests that in a free market, exchange rates are determined by the forces of demand and supply. And demand and supply of currency is determined by the volume of imports and exports. When we import goods, services etc from other countries, demand of their currency increases resulting in devaluation of home currency in terms of that currency and when we export the same, the value of home currency strengthens as foreign exchange flows inward and its supply increases.

In a country like Pakistan where exports are not more than half of imports, value of currency should decrease by almost same ratio. The difference of imports and exports is Balance of Payments which in case of Pakistan is deficit. Deficit BOP causes depression on home currency because demand for foreign exchange increases as it flows outwards and country has to borrow to pay for imports as exports are not generating enough foregin exchange.

To test this theory we developed a model which takes historical data of both PKR (USD=1) and BOP (Accumulated) and presents it on a chart to show the relationship of both.

By looking at the chart, it is proved that BOP has indeed an impact on exchange rate. How much? that is the question. First of all, the primary assumption of theory is "free market", however PKR has been controlled by GoP upto some extent. For example, during 2008-2013, PKR was controlled less and it adjusted itlesf by falling and then following the BOP pattern. Than in 2014, PMLN Nawaz Government started controlling PKR and it maintained its course despite BOP getting further deficit. The result was sudden downfall of PKR in 2019 when the controlls were lifted by PTI Governmet.

Theoratically PKR line should overlap BOP line and follow the same course (provided the market is free).

PKR = PKR/USD
BOP = Accumulated BOP in USD Million
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