Foreign exchange rate

The essentials

The foreign exchange rate is the price of one currency in terms of another, for example ₹85 per US dollar. Foreign exchange is demanded to import goods and services, to travel abroad, to invest abroad and to speculate. It is supplied when foreigners buy domestic exports, tourists visit, foreigners invest in the country, and residents receive remittances.

Exchange rate systems

• Flexible (floating) exchange rate: set by market demand and supply of foreign exchange, without government intervention. Equilibrium is where the demand curve (downward-sloping: a higher rupee price of the dollar makes imports dearer, so less dollar is demanded) meets the supply curve (upward-sloping: a higher rupee price of the dollar makes Indian goods cheaper for foreigners, so exports and dollar supply rise).
• Fixed exchange rate: set by the government or central bank, which buys or sells foreign exchange to hold the rate. Lowering the official value of the domestic currency is devaluation; raising it is revaluation.
• Managed floating: the rate is mostly market-determined, but the central bank intervenes to prevent sharp swings. India follows a managed floating system.

Key points

• Depreciation: a fall in the value of the domestic currency under a flexible rate (₹80 to ₹85 per dollar means the rupee has depreciated).
• Appreciation: a rise in its value under a flexible rate.
• Merits of fixed rates: stability and certainty for trade. Demerits: needs large reserves and may lead to over- or under-valuation.
• Merits of flexible rates: no need for large reserves and automatic adjustment of BoP. Demerits: uncertainty and speculation.

Exam tips

Remember that depreciation and appreciation happen through the market, while devaluation and revaluation are deliberate official acts under a fixed rate.

Common mistakes

• Reading a rise in ₹ per dollar as rupee appreciation; it is depreciation.