Exchange Rate – Types & Determination
🟠 Topic 64: Exchange Rate – Types & Determination
📌 Introduction
The exchange rate is one of the most critical economic indicators for any country. It reflects the value of a nation’s currency vis-à-vis foreign currencies and plays a key role in international trade, capital flows, and macroeconomic stability. For a globally integrated economy like India, understanding the types, determination factors, and impacts of exchange rates is essential.
🔹 What is Exchange Rate?
📖 Definition
The exchange rate is the price of one currency in terms of another currency. For example, if 1 USD = ₹83, this means ₹83 are needed to buy 1 USD.
Key Roles of Exchange Rate
✔️ Facilitates international trade and investment.
✔️ Impacts inflation, external debt, and competitiveness.
✔️ Reflects economic health and investor confidence.
✔️ Influences foreign exchange reserves.
🔹 Types of Exchange Rates
1️⃣ Fixed Exchange Rate
- Government or central bank pegs domestic currency to a foreign currency (like USD) or a basket of currencies.
- Central bank intervenes to maintain the pegged rate.
| Example | Country |
|---|---|
| Peg to USD | Saudi Arabia |
| Basket Peg | Kuwait |
✅ Ensures stability, but loses monetary policy independence.
2️⃣ Floating Exchange Rate
- Determined by market forces of supply and demand.
- Central bank rarely intervenes, unless volatility threatens stability.
| Example | Country |
|---|---|
| Floating | USA, EU, India (managed float) |
✅ Flexible, reflects real economic strength.
3️⃣ Managed Float (Dirty Float)
- Currency value is market-determined, but central bank occasionally intervenes to manage volatility.
- India follows managed float regime.
| Example | Country |
|---|---|
| Managed Float | India, China |
✅ Balances market forces with central bank stability actions.
4️⃣ Dual Exchange Rate
- Different rates for current account (trade) and capital account (investment) transactions.
- Often used in crisis-hit economies.
| Example | Country |
|---|---|
| Dual Rate (historical) | Myanmar (earlier), Venezuela |
✅ Helps manage capital outflows, but creates distortions.
5️⃣ Currency Board
- Domestic currency backed 100% by foreign currency reserves.
- Exchange rate is legally fixed.
| Example | Country |
|---|---|
| Currency Board | Hong Kong |
✅ Credibility enhanced, but lacks flexibility.
🔹 Exchange Rate Regime in India
- India follows a managed floating exchange rate system.
- The RBI intervenes occasionally to smoothen excessive volatility.
🔹 Determinants of Exchange Rate
1️⃣ Demand & Supply of Foreign Exchange
- Higher demand for imports, foreign investments, or external debt servicing increases demand for USD, depreciating rupee.
- Higher exports, remittances, and FDI inflows increase supply of USD, appreciating rupee.
2️⃣ Inflation Differential
- Countries with higher inflation see currency depreciation.
- Lower inflation economies have stronger currencies.
3️⃣ Interest Rate Differential
- Higher interest rates attract capital inflows, strengthening the currency.
- Lower rates trigger capital outflows, weakening currency.
4️⃣ Current Account Deficit (CAD)
- Persistent CAD weakens currency, as more foreign exchange is required to finance trade deficits.
5️⃣ Foreign Investment
- Inflows via FDI and FPI strengthen currency.
- Outflows due to global risk aversion weaken currency.
6️⃣ Forex Reserves
- Higher reserves boost investor confidence, supporting currency value.
- Low reserves trigger speculative attacks, weakening currency.
7️⃣ Political Stability & Economic Confidence
- Political uncertainty and weak macroeconomic indicators trigger capital flight, depreciating currency.
- Strong economic outlook supports currency appreciation.
8️⃣ Speculation
- Currency traders’ speculation on future movements can exacerbate volatility.
🔹 Key Exchange Rate Concepts
1️⃣ Nominal Exchange Rate
- Market price of domestic currency vis-à-vis foreign currency.
- Example: ₹83/USD.
2️⃣ Real Exchange Rate (RER)
- Adjusted for inflation differences between trading partners.
- Indicates competitiveness.
✅ Formula:
RER=Nominal Exchange Rate×Domestic Price LevelForeign Price LevelRER = \frac{Nominal \ Exchange \ Rate \times Domestic \ Price \ Level}{Foreign \ Price \ Level}
3️⃣ Effective Exchange Rate
- Weighted average exchange rate with major trading partners.
- Reflects overall competitiveness.
4️⃣ Real Effective Exchange Rate (REER)
- Adjusted for inflation differentials with trading partners.
- REER > 100 = Overvalued currency.
- REER < 100 = Undervalued currency.
🔹 RBI’s Role in Exchange Rate Management
✔️ Monitors forex markets daily.
✔️ Intervenes to: ✔️ Smoothen volatility.
✔️ Build reserves.
✔️ Prevent speculative attacks.
✔️ Uses tools like: ✔️ Dollar-Rupee Swaps.
✔️ Open Market Sales/Purchases.
✔️ Forex Forward Contracts.
🔹 Impact of Exchange Rate Fluctuations on Economy
| Sector | Impact of Depreciation |
|---|---|
| Exports | More competitive |
| Imports | More expensive |
| Inflation | Higher (imported inflation) |
| External Debt | Becomes costlier |
| Tourism & Education Abroad | Becomes expensive |
Case Study – Rupee Depreciation in 2022
- Rupee fell to a record low of ₹83/USD due to: ✔️ Global energy price surge post-Ukraine war. ✔️ Capital outflows triggered by US Fed rate hikes. ✔️ Widening trade deficit.
- RBI used forex reserves to stabilize rupee.
🔹 Trends in INR/USD Exchange Rate
| Year | Exchange Rate (₹ per USD) |
|---|---|
| 2010 | 45 |
| 2015 | 63 |
| 2020 | 74 |
| 2023 | ~83 |
Factors Behind Long-term Rupee Depreciation
✔️ Structural trade deficit.
✔️ Higher domestic inflation than trading partners.
✔️ Periodic capital outflows during global crises.
✔️ Rising external debt obligations.
📚 Practice MCQ
1️⃣ Which of the following is a characteristic of a fixed exchange rate system?
✅ Options:
(a) Determined by supply and demand
(b) Pegged by government or central bank
(c) Highly volatile
(d) Set by international markets
2️⃣ Which of the following factors can lead to rupee depreciation?
- Increase in crude oil prices
- Higher Current Account Deficit
- Increase in foreign portfolio inflows
✅ Options:
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1, 2, and 3
(d) 1 only
3️⃣ What does REER > 100 indicate for the Indian Rupee?
✅ Options:
(a) Rupee is undervalued
(b) Rupee is overvalued
(c) Exchange rate is stable
(d) There is trade surplus
