Let’s understand what is exchange rate. Exchange rate is either fixed or floating. Fixed exchange rate is decided by the Central Bank (RBI in the case of India). Floating exchange rate is decided by supply and demand. (Market Mechanism). Exchange rate is the value of one currency vis-à-vis another currency. The main buyers and sellers of currency are commercial banks, RBI, foreign exchange brokers, students and Companies.
If exchange rate between domestic and foreign currencies are fixed by a monetary authority (say RBI of India), and fluctuations are not allowed beyond a limit, this is fixed exchange rate.
See Also: Foreign Exchange Market In India
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SEE ALSO: What is Fixed Exchange Rate
What Is Exchange Rate?
Types of Exchange Rate:
Fixed Exchange Rate: Under the International Monetary Fund IMF system, the monetary authority of a member nation (say RBI of India in this case), fixes the official value of its currency (Rupee in this case), with the Reserve Currency (US Dollar) or a basket of key currencies. This is pegged exchange rate. IMF allows a fluctuation of 1% up or down within set limits. India doesn’t have a fixed rate exchange economy.
Floating Exchange Rate: The exchange rate is determined by forces of demand and supply. The currency is allowed to fluctuate freely, based on demand and supply of foreign exchange. The Central Bank doesn’t intervene and allows the currency to adjust freely, based on demand and supply.
Managed Float: India follows managed float. The exchange rate fluctuates each day, but RBI intervenes to influence India’s exchange rate by buying and selling currencies like the US Dollar.
The purpose of managed float is to protect your currency from economic shocks and speculation. If a central bank manipulates exchange rate to the disadvantage of other countries, this is dirty float.
Exchange rate determination:
Let’s understand how a floating exchange rate works. The demand of the currency is determined by market forces. Let’s take the case of the Indian Rupee and the US Dollar. The value of the rupee and the dollar is determined by the demand and supply of the currencies.
See Also: Foreign Exchange Market In India
Currency Exchange rates India Vs Other Countries:
Demand for US Dollars:
What happens if rupee appreciates against dollar? Let’s say the rupee appreciates/gains against the dollar. The US goods get cheaper in terms of rupees. Indians and firms import more from the US. This raises the demand for dollars.
What happens if rupee depreciates against dollar? Let’s say the rupee depreciates/loses against the dollar. US goods would cost more making them expensive. This discourages US imports and results in a decrease in demand for dollars.
Supply of US Dollars:
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If the rupee depreciates against dollar (lower value of rupee vis-à-vis dollar), Rs 100 worth of goods would be relatively cheaper in terms of dollars. This boosts imports of Indian goods to the US and payment is received in dollars. This ensures higher supply of dollars in the foreign exchange market.
If the rupee appreciates against dollar (higher value of rupee vis-à-vis dollar), then Rs 100 worth of goods would be relatively expensive in terms of dollars. This discourages Indian exports to the US. This means reduced quantity of dollars in the foreign exchange market. Market forces (demand and supply) eventually determine equilibrium exchange rate.
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