Meaning
An exchange rate is the price of one country’s currency expressed in terms of another currency.
For example, if:
US$1 = ₹85
it means ₹85 are required to purchase one US dollar.
Exchange rates influence:
- exports and imports;
- foreign investment;
- inflation;
- external debt;
- tourism and remittances;
- foreign-exchange reserves.
A currency depreciates when its value falls relative to another currency and appreciates when its value rises.
Types of Exchange Rate Systems
Fixed Exchange Rate
The government or central bank maintains the currency at a predetermined value against another currency or a basket of currencies.
Floating Exchange Rate
The currency’s value is largely determined by demand and supply in the foreign-exchange market.
Managed Floating Exchange Rate
Market forces determine the exchange rate, but the central bank may intervene to reduce excessive fluctuations.
India broadly follows a market-determined managed-float system. The Reserve Bank of India does not maintain a permanently fixed rupee-dollar rate but may intervene when market movements become disorderly.
Determinants
Exchange rates are influenced by several factors.
Inflation
Countries with persistently higher inflation may experience currency depreciation because their goods become relatively more expensive.
Interest Rates
Higher interest rates may attract foreign capital, increasing demand for the domestic currency.
Trade Balance
Strong export earnings increase demand for the domestic currency, while large import payments increase demand for foreign currency.
Capital Flows
Foreign direct investment and portfolio investment can strengthen the domestic currency, while capital outflows can weaken it.
Other factors include:
- economic growth;
- crude-oil prices;
- government debt;
- political stability;
- global risk sentiment;
- central-bank intervention;
- market expectations.
Appreciation and Depreciation
Suppose the exchange rate changes from:
US$1 = ₹80 to US$1 = ₹85
The rupee has depreciated because more rupees are required to purchase one dollar.
Rupee depreciation can:
- make Indian exports more competitive;
- make imports more expensive;
- raise the cost of imported crude oil and machinery;
- increase repayment costs of foreign-currency debt;
- increase the rupee value of remittances received from abroad.
If the rate moves from ₹85 to ₹80 per dollar, the rupee has appreciated.
Appreciation can make imports cheaper but may reduce the price competitiveness of exports.
Indian Context and Policy
India’s exchange rate is influenced heavily by:
- crude-oil imports;
- foreign portfolio investment;
- US interest rates;
- global dollar movements;
- merchandise and services exports;
- remittances;
- foreign direct investment.
The RBI may buy or sell foreign currency to smooth excessive volatility.
When the rupee depreciates sharply, the RBI may sell dollars and buy rupees.
When the rupee appreciates excessively, the RBI may buy dollars and supply rupees.
However, exchange-rate management cannot permanently override economic fundamentals. Persistent inflation, weak external balances or sustained capital outflows cannot be solved only through foreign-exchange intervention.
Conclusion
The exchange rate connects the domestic economy with the international financial system. Its movement affects trade, inflation, investment and external stability, making orderly exchange-rate management an important part of macroeconomic policy.
