Exchange Rates: Things You Need To Know

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

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

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

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 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

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

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