The origin of modern Foreign Exchange theory

The origin of modern Foreign Exchange theory, as we know it today, dates from the latter part of the first World War. Before 1914 no attempt was made to analyse the influences behind the balance of payments theory, while the purchasing power parity theory faded virtually into oblivion during a century of relative stability. Although it would be incorrect to say that Foreign Exchange theory stagnated between the publication of Goschen Theory of the Foreign Exchanges in 1861 and the revival of the purchasing power parity theory by Cassel in 1916, its progress was certainly very slow in comparison with its truly spectacular development during the ten years or so after 1916. While in the decades before the first World War most leading economists paid relatively little attention to Foreign Exchange theory, in the second half of that war, and even more in the early post-war period, most prominent monetary economists and even some general economists took a very active interest in it.

The following is a summary of the main achievement of Foreign Exchange theory since 1914:

The purchasing power parity theory was revived and was developed very thoroughly.

The theory of prices being determined by exchange rates was carried further.

A synthesis between the two theories was produced in the form of the equilibrium theory.

The balance of payments theory was carried further.

Attempts were made to reconcile the purchasing power parity theory with the balance of payments theory.

The psychological theory was developed further.

Elasticities in the Foreign Exchange market and in the factors determining the supply and demand of exchanges received attention.

Differentiation between static and dynamic theory made some slight progress.

Relationship between business cycles and exchange rates was analysed.

A Forward Exchange theory was created and developed.