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. |
Types of exchange rate
Nominal exchange rate |
Real exchange rate |
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Real effective exchange rate (REER) |
Nominal effective exchange rate (NEER) |
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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
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
Devaluation
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Revaluation
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Depreciation
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Appreciation
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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
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 |