Exchange Rates: Things You Need To Know

Introduction

The exchange rate is the price of a country’s currency in terms of another country’s currency.


How to calculate Exchange rate?


  • It is calculated by relating the value of one currency to other country currency
  • In mathematical terms, Exchange rate = (price of domestic currency)/(price of foreign currency)
  • Example: $1 = 65 rupees implies that one has to give 65 rupees to get $1

Who determines Exchange rate?


  • After World War II, World Bank and IMF were formed to reconstruct the war-torn world nations
  • IMF determined the exchange rate initially with the quota of the developed nations
  • Later, UK withdraw from the fixed rate regime and fixed its own currency rate depending on market conditions
  • Gradually, countries also started moving to the floating currency regime
  • Currently, the central bank of nations have the power to determine the exchange rate by buying and selling currencies in the foreign exchange market

How to determine Exchange rate?


  • To determine the exchange rate, there are three generally used methods
  • Fixed exchange rate
  • Floating exchange rate
  • Crawling peg exchange rate

Fixed Exchange Rate


  • Also called as pegged exchange rate
  • Central bank of a nation fixes and maintains the exchange rate
  • The domestic price of the currency will generally be set against US dollar or other world currency like Euro, Yen or IMF basket of currencies
  • Central bank will sell and buy its own currency from the foreign exchange market against the pegged currency
  • RBI has been following the fixed exchange rate till 1991
  • Now complete fixed exchange rate regime has come to an end and only a combination of fixed and floating rate are employed in the foreign exchange market

Floating Exchange Rate


  • Floating exchange rate is determined by demand and supply prevailing in the market
  • Rate determined solely by the market
  • Exchange rate constantly changes periodically (even on daily basis)
  • Also termed as the self-correcting exchange rate
  • When the demand for a currency in foreign exchange market becomes low, then its imports become expensive and ultimately its value will decrease
  • This will cause heavy demand for goods and services domestically
  • This, in turn, results in the creation of more jobs domestically
  • Thus an automatic correction is made balancing the demand and supply in the floating currency regime
  • The exchange rate changes in global scenario will affect the domestic currency in the floating rate regime
  • Currently, this is the widely accepted and adopted currency regime by the world nations

Crawling Peg Exchange Rate


  • Also known as Dirty Floating rate
  • This is a combination of fixed and floating exchange rate
  • Government allows the currency to fluctuate freely in a given band determined by the central bank
  • Once the currency exceeds the band fixed by central bank, Government intervenes in the foreign exchange market to stabilise the domestic economy

Implications of Exchange rate


  • Appreciation of exchange rate or rupee appreciation implies rise in exchange rate of rupee
  • Depreciation of exchange rate or rupee depreciation implies fall in exchange rate of rupee
  • Both appreciation and depreciation of currency occurs as a result of change in supply and demand of the currency in the foreign exchange market
  • Depreciation of currency favours exports and makes imports costlier
  • Appreciation of currency favours imports and makes exports costlier
  • Devaluation of currency is similar to depreciation of currency
  • India devalued its currency during the 1991 Balance of Payment crisis
  • Recently China devalued its currency Yuan
  • RBI has the power to devalue the rupee by selling more rupees and buying dollars from the foreign exchange market
  • Similarly, RBI can revalue the rupee by selling dollars and buying rupees
  • The activities of devaluation and revaluation of currency are associated with the fixed exchange rate regime



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