Exchange Rate System

What is the exchange rate?

When one country's currency is converted into another country's currency, the rate at which one currency is exchanged for another is referred to as the "exchange rate” or “foreign exchange rate." In other words, it is a price at which domestic currency is exchanged for another currency.  

For example, the exchange rate from Indian rupees to dollars was 70, which means 70 rupees buy $1.

The two components of the exchange rate are

  • Domestic currency
  • Foreign currency

Where do currencies exchange?

In the Exchange rate market

  • It is a place where currencies get exchanged.
  • The exchange market is also known as forex, FX, or the currencies market.
  • The primary objective of the foreign currency market is to establish this connection (price) for global markets.
  • The foreign exchange markets are composed of banks, forex dealers, commercial businesses, central banks, investment management companies, hedge funds, small-scale forex dealers, and investors.
    • The dealers in the market are authorized dealers. 
    • In the case of India, it can be banks or non-banks and is registered with the RBI under the FEMA (Foreign Exchange Management Act).
  • Because currencies are usually exchanged in pairs, the "value" of one currency in that pair is related to the value of the other. This regulates the maximum amount of currency from nation A that country B may purchase, and vice versa. 

Factors that affect the exchange rate

  • Inflation

An increase in the inflation rate can raise demand for foreign currency, which can have a negative influence on the domestic currency's exchange rate. For example, an increase in the price of oil might boost demand for foreign money, causing the domestic currency to depreciate.

  • A country with a consistently low inflation rate sees its currency value rise as its buying power rises relative to other currencies. Countries with high inflation often see their currency depreciate in relation to their trading partners' currencies.
  • Interest Rates
  • Interest rates on government securities and bonds, corporate securities, and so on influence the outflow and inflow of foreign money.
    • If interest rates on government bonds are greater than in other countries' forex markets, it can encourage foreign currency inflows, whereas lower interest rates can cause foreign currency outflows. This will have an impact on the country's exchange rate.
  • Lower interest rates tend to cause exchange rates to fall, whereas higher interest rates tend to cause exchange rates to rise.
  • Government intervention
    • During periods of extreme volatility in the exchange rate, the central bank intervenes to keep the exchange rate from getting out of control.
      • For example, the RBI sells dollars when the Indian rupee falls too much, and it buys dollars when the Indian rupee rises over a specific level.
    • Central banks control both inflation and exchange rates by regulating interest rates, and changes in interest rates affect both inflation and currency values. Higher interest rates provide lenders in an economy with a larger return in comparison to other countries.
  • Current Account
    • Exports and imports have an impact on the exchange rate because exports produce foreign currency while imports need payment in foreign currency.
      • Hence, if total exports grow, the national currency gains, but increases in imports cause the national currency to depreciate.
    • For instance, a current account deficit indicates that the country is spending more on foreign commerce than it is earning and that it is borrowing cash from foreign sources to make up the difference. 
      • In other words, the country needs more foreign currency than it receives through export sales, and it supplies more of its own currency than foreigners desire for its goods. 
      • Excess foreign currency demand lowers the country's exchange rate until domestic goods and services are affordable to foreigners and foreign assets are too expensive for domestic consumers.
    • In addition to these factors, the Indian foreign exchange market is also influenced by factors such as receipts in accounts of exports invisible in the current account, inflows in the capital account such as FDI, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities, and so on.

The exchange rate is determined by–

  • Demand and supply of the currency
  • Government Intervention  

 In India, the exchange rate is not totally set by the market.
 The RBI occasionally intervenes in the foreign exchange market to guarantee that the rupee does not fluctuate excessively.

Types of exchange rate

 Nominal exchange rate

 Real exchange rate

  1. It is defined as the number of domestic currency units needed to buy one unit of a given foreign currency.
  2. When the nominal exchange rate falls, the currency's nominal appreciation occurs.
  3. When a country has a floating exchange rate regime, the nominal exchange rate falls, which is known as appreciation.
  4. A high nominal exchange rate may make it seem that a unit of home currency can buy a lot of foreign items, although only a high real exchange rate supports this concept.
  5. Monetary policy, which influences the rate of domestic inflation, can have an impact on the nominal exchange rate.
  6. It helps determine the real exchange rate by converting the foreign price level into domestic currency units using the current nominal exchange rate.
  1. The real exchange rate between two currencies is computed by multiplying the nominal exchange rate by the price ratio of the two nations.
  2. It indicates how often a good or service may be purchased in times a good or service may be purchased foreign countries (after conversion into a foreign currency) for a certain amount that often a good or service may be purchased in n in the domestic market.
  3. The real exchange rate is calculated in terms of a broad basket of products to measure purchasing power when nations export more than one commodity.
  4. When the real exchange rate becomes overvalued, the nominal exchange rate is under pressure to adjust since the same items may be purchased significantly cheaper in one nation than the other.
    1. Overvalued currencies are under pressure to devalue, whereas undervalued currencies are under pressure to rise.
  5. It can also be impacted by policy changes that hinder normal equilibration of exchange rates, which is frequently a cause for trade disputes


 Real effective exchange rate (REER)

 Nominal effective exchange rate (NEER)

  1. The real effective exchange rate is the weighted average of a country's currency against an index or basket of other major currencies.
    1. The weightage is determined by comparing a country's currency's relative trade balance against each country in the index.
  2. This exchange rate is used to calculate the worth of a country's currency in relation to the other main currencies in the index.
  3. It eliminates the influence of currency inflation differentials and concentrates solely on the exchange rate differential.
  4. It is calculated using the NEER.
  5. Because it is adjusted for inflation, it is considered a more accurate estimate.
  1. The unadjusted weighted average rate at which one country's currency is exchanged for a basket of foreign currencies is known as the nominal effective exchange rate. 
  2. The nominal exchange rate affects the amount of domestic currency needed to acquire foreign currency.
  3. The trade-weighted currency index measures a country's international competitiveness in the foreign exchange (forex) market.
  4. It is assessed against a currency basket.
  5. Because of the inflation differential, it may differ in providing accurate measurements.

Types of Exchange Rates regime

  • Fixed exchange rate regime   
  • Under the fixed exchange rate regime the government sets the exchange rate for the currency by intervening in the exchange market.
  • The central bank ( in India it is the RBI) or the government keeps the exchange rate stable.
    • To keep the exchange rate stable, the central bank or government buys foreign exchange when the rate increases and sells foreign exchange when the rate falls.
    • As a result, the government must keep huge reserves of foreign currency in order to maintain a stable exchange rate. This is referred to as pegging.  
    • Because of this, the fixed exchange rate system is sometimes referred to as the pegged exchange rate system.
  • Under this regime, the exchange rate can be influenced by the central bank; only no market factor can influence the exchange rate. 
  • The terms "devaluation" and "revaluation" refer to the respective weakening and strengthening of the domestic currency.

Advantages of the regime

  • It promotes foreign trade by ensuring currency stability.
  • The value of a currency is stable, which protects it from market volatility.
  • It encourages foreign investment in the country.
  • It aids in the maintenance of steady inflation rates in an economy.

Drawbacks of the regime

  • Maintaining foreign reserves is always necessary in order to keep the economy stable.
    • There is a need for large gold reserves. 
    • As a result, it impedes the movement of capital or foreign exchange.
  • It may cause the currency to be undervalued or overvalued.
  • That violates the goal of having open markets.
  • This system may make it difficult for a country to deal with depression or recession.

 methods of fixed exchange rates used in the past

  •  The Gold Standard System (1870-1914)
  •  According to this system, gold was chosen as the common unit of parity between different countries' currencies. 
  • Each country specifies its currency's value in terms of gold. As a result, the value of one currency is fixed in terms of the currency of another country after taking into account the gold value of each currency.
  • Bretton Woods System (1944-1971)
  • This system replaced the gold standard system. 
  • This system was implemented to improve system clarity. 
  • Even in the fixed exchange rate, it permitted certain modifications, so it is called the 'adjusted peg system of exchange rate'.
  • Countries were required to fix their currencies against the US Dollar ($) under this arrangement.
  • The US Dollar was given a fixed gold value.
  • The value of one currency was pegged in terms of the US Dollar, implying the currency's worth in gold.
  • Gold was regarded as the ultimate unit of parity.
  • The International Monetary Fund (IMF) served as a major governing organization under this system.

 This is the system that was phased out in favor of the flexible exchange rate in 1977.

Flexible Exchange Rate regime

  • Under this regime, the exchange rate is determined by the market forces of demand and supply in the foreign exchange market. 
  • This is also known as the Floating Rate of Exchange or the Free Exchange Rate. 
  • It is named flexible because the rate adjusts in response to changes in market conditions.
  • The government does not intervene in the Flexible Exchange Rate system.
  • The exchange rate is set by the interactions of banks, businesses, and other entities in the foreign exchange market that seek to purchase and sell foreign currency.
  • Under this system, a country can get easy access to loans from international financial institutions.
  • In this system, when the currency weakens it is called “depreciation”, and the strengthening of the currency is called “appreciation”.

Advantages of a Flexible Exchange Rate System

  • The government is not required to keep any reserves under the flexible exchange rate regime.
  • It resolves the issue of currency overvaluation or undervaluation.
  • It promotes venture capital in the form of foreign currency.
  • It also improves resource allocation efficiency.

Disadvantages of the Flexible Exchange Rate System

  • It encourages currency speculation.
  • The economy lacks stability since the currency rate fluctuates based on demand and supply.
  • Coordination of macroeconomic policies becomes inconvenient as a result.
  • There is economic uncertainty, which hampers foreign trade and investment.

Managed Floating Exchange Rate System

  • It is a combination of both fixed and flexible systems 
  • It has both the components 
    • controlled component
    • the floating part
  • It refers to a system in which the foreign exchange rate is set by market forces and the central bank stabilizes the exchange rate in the event of domestic currency appreciation or depreciation.
  • The exchange rate is not decided by the central bank.
  • To manage the fluctuation in the currency rate, the central bank functions as an intermediary to buy or sell foreign exchange.
  • When the exchange rate is high, the central bank sells foreign exchange to bring it down, and vice versa.
  •  It is done to safeguard importers' and exporters' interests.
  • This regime is classified into 4 categories
 Adjusted Peg System

 The central bank attempts to maintain the domestic currency exchange rate until the country's foreign exchange reserves   are absorbed. 

 The central bank devalues the home currency in order to shift the exchange rate to a new equilibrium.

 Crawling Peg System

 The central bank continues to alter the exchange rate depending on fresh demand and supply situations in the exchange   rate market.

 It adheres to a system of frequent checks and balances, and the central bank conducts minor devaluations based on   market conditions.

 Clean Floating System

 Under this, domestic currency exchange rates are determined by market forces such as demand and supply, with no   interference from the government or central bank.

 This system is the same as a floating exchange rate.

 Dirty Floating System

 Under this, the exchange rate is allowed to fluctuate, but the central bank can intervene to keep it within a specific range   or  to avoid it from moving in an undesirable direction.

 The purpose is to reduce currency volatility and enhance economic stability.

Terms that are useful in the exchange rate

      1. It includes the government's reduction in the value of the domestic currency in terms of foreign currencies under a fixed exchange rate regime.
      2. It is done by the government.
        1. To stabilize the economy
        2. To boost the aggregate demand
      1. Current account improvement- exports are cheaper and imports are expensive
        1. It increases the competitiveness of domestic exports in the foreign markets and improves the trade balance by increasing the foreign value of domestic currency
      2. High inflation
      3. Positive impact on economic growth
      1. The price of the domestic currency rises in relation to foreign currency during a revaluation.
      2. It is typically used under a fixed exchange rate regime, in which the central bank or government determines the exchange rate.
      3. The reverse of devaluation is revaluation, a downward adjustment in the country's official currency rate.
        1. To manage the inflation in the economy
        2. To reduce the current account surplus
      1. It raises a currency's value with respect to other currencies. 
      2. This reduces the cost of purchasing imported items in foreign currency for local importers. 
      3. Domestic exporters suffer a decrease in export activity as exporting goods becomes more expensive to foreign importers.
      1. When the exchange rate falls.
      2.  It indicates that the domestic currency weakens.
      3. It happens under the floating exchange rate system.
      4. It is done by the market forces of demand and supply.
        1. reasons for depreciation
        2. Reduced export revenues
        3. Rise of imports.
        4. Monetary policy
        5. The central bank intervention
        6. The currency traded by market traders and speculators
      1. The depreciation results in a surplus of the current account and a deficit also.
        1. Exports will rise due to the depreciation which will improve the current account while on the other hand, the demand for goods will increase, raising the prices of the goods and creating cost-push inflation.
      2. Foreign exchange (forex) reserves fall.
    1. When the exchange rate rises the currency appreciates. In simple words, the domestic currency can now buy more of the foreign currency.
    2. It happens under the floating exchange rate.
    3. It occurs due to market forces.
    4. Reason- demand and supply of the currency
    5. Effect- cheaper imports and expensive exports.


Prelim Questions

 With reference to the Indian economy, consider the following statements :

1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.

2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.

3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.

Which of the above statements are correct ?

a. 1 and 2 only

b. 2 and 3 only

c. 1 and 3 only

d. 1, 2 and 3

Consider the following statements:

The effect of devaluation of a currency is that it necessarily 

1. improves the competitiveness of the domestic exports in the foreign markets.

2. increases the foreign value of domestic currency.

3. improves the trade balance.

 Which of the above statements is/are correct?

(a) 1 Only

(b) 1 and 2

(c) 3 Only

(d) 2 and 3


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