Exchange Rate

An exchange rate is the price of one currency expressed in terms of another. It determines how much of one country’s currency can be exchanged for another’s and plays a central role in international trade, investment, and finance. Exchange rates affect import and export prices, the balance of payments, inflation, and overall economic stability.
For example, if 1 U.S. dollar (USD) equals 83 Indian rupees (INR), this means one dollar can be exchanged for 83 rupees.

Definition

An exchange rate can be defined as:

“The rate at which one currency can be converted into another, reflecting the relative value of the two currencies in the foreign exchange (forex) market.”

It represents the terms of trade between countries and serves as the foundation for international financial transactions.

Types of Exchange Rates

Exchange rates are generally classified based on how they are determined and managed by a country’s monetary authority.

1. Fixed (Pegged) Exchange Rate

• The value of a country’s currency is tied or pegged to another major currency (e.g., U.S. dollar, euro) or a basket of currencies.
• The central bank maintains this rate by buying or selling foreign currency in the market.
• Provides stability in international prices but limits monetary policy flexibility.
• Example: The Saudi riyal is pegged to the U.S. dollar.

2. Floating (Flexible) Exchange Rate

• Determined by market forces of supply and demand in the foreign exchange market without direct government intervention.
• The rate fluctuates continuously based on trade flows, capital movements, and economic performance.
• Example: The U.S. dollar, the euro, and the Japanese yen have floating rates.

3. Managed Floating (Dirty Float)

• A hybrid system where the exchange rate is mostly market-determined but the central bank occasionally intervenes to stabilise volatility.
• India follows a managed float system, where the Reserve Bank of India (RBI) intervenes to reduce excessive fluctuations.

4. Dual Exchange Rate System

• Two exchange rates coexist: one official rate (set by the government) and one market rate (determined by supply and demand).
• This system is sometimes used in developing economies to manage both essential imports and market activities.

Methods of Quoting Exchange Rates

1. Direct Quotation:
   • The value of foreign currency is expressed in terms of the domestic currency.
   • Example (India): 1 USD = ₹83.00.
2. Indirect Quotation:
   • The value of domestic currency is expressed in terms of the foreign currency.
   • Example (U.S.): ₹1 = 0.012 USD.
3. Spot Exchange Rate:
   • The rate applicable for immediate delivery (usually within two business days).
4. Forward Exchange Rate:
   • The rate agreed upon today for exchanging currencies at a future date, used to hedge against exchange rate risks.

Determinants of Exchange Rates

Several economic, financial, and political factors influence exchange rates. Key determinants include:

1. Demand and Supply of Currencies:
   • When exports rise, demand for a country’s currency increases, leading to appreciation.
   • When imports rise, demand for foreign currency increases, leading to depreciation.
2. Interest Rate Differentials:
   • Higher domestic interest rates attract foreign capital, increasing currency demand and value.
3. Inflation Rate:
   • Lower inflation in a country enhances the purchasing power of its currency, leading to appreciation.
4. Balance of Payments (BoP):
   • A surplus in BoP (exports > imports) strengthens the domestic currency; a deficit weakens it.
5. Speculation and Market Sentiment:
   • Expectations of future currency movements influence current demand and supply.
6. Government and Central Bank Intervention:
   • Buying or selling foreign currencies can influence exchange rate stability.
7. Political Stability and Economic Performance:
   • Stable governments and growing economies attract investors, leading to stronger currencies.

Appreciation and Depreciation

• Appreciation: When the value of a currency rises relative to another.
  • Example: If USD/INR moves from 83 to 80, the rupee has appreciated.
• Depreciation: When the value of a currency falls relative to another.
  • Example: If USD/INR moves from 80 to 83, the rupee has depreciated.

In fixed systems, the terms revaluation and devaluation are used instead.

Theories of Exchange Rate Determination

Several economic theories explain how exchange rates are determined:

1. Purchasing Power Parity (PPP) Theory:
   • States that exchange rates adjust to equalise the price of identical goods in different countries.
   • Example: If a good costs ₹830 in India and $10 in the U.S., the exchange rate should be ₹83 = $1.
2. Interest Rate Parity (IRP):
   • Suggests that differences in interest rates between two countries are offset by changes in forward exchange rates.
3. Balance of Payments Theory:
   • Exchange rates are determined by the supply and demand for foreign currency arising from trade, investment, and transfers.
4. Monetary Approach:
   • Emphasises the role of money supply and demand; an increase in money supply leads to depreciation.
5. Asset Market Approach:
   • Views currencies as financial assets whose value depends on expected returns and risk.

Importance of Exchange Rates

1. International Trade:
   • Determines export and import competitiveness. A weaker currency boosts exports, while a stronger currency makes imports cheaper.
2. Investment Decisions:
   • Influences foreign direct investment (FDI) and portfolio investment flows.
3. Inflation Control:
   • Exchange rate movements affect import prices and domestic inflation.
4. Economic Growth:
   • Stable exchange rates promote trade, investment, and overall economic confidence.
5. Monetary Policy Transmission:
   • Central banks use exchange rate adjustments as part of monetary and fiscal strategies.

Exchange Rate Regime in India

India follows a managed floating exchange rate system since 1993, when it moved away from a fixed regime.

• The value of the Indian rupee is primarily determined by market forces.
• The Reserve Bank of India (RBI) intervenes periodically to control excessive volatility and maintain orderly conditions in the forex market.
• India’s exchange rate policy aims to maintain stability without rigidity.

Exchange Rate Volatility and Its Effects

Fluctuating exchange rates can have wide-ranging economic impacts:

• For Exporters: Currency depreciation makes exports more competitive.
• For Importers: Currency depreciation raises import costs.
• For Investors: Exchange rate risk affects returns on foreign investments.
• For Consumers: Changes in import prices can influence domestic inflation and purchasing power.