Explained: Making sense of exchange rate

News: Indian rupee hit an all-time low exchange rate of 77.6 against the US dollar.

What is the exchange rate?

The exchange rate tells us how much of a currency (e.g. Rupee) is required to purchase one unit of another currency (e.g. Dollar). For example, if the rupee’s exchange rate “falls”, it implies that buying American goods would become costlier.

How an exchange rate is determined?

In a free market, the exchange rate is determined by the supply and demand for currencies, i.e. rupees and dollars. For example, in case Indians demand more dollars in comparison to the demand of rupees in America, the value of rupees will depreciate.

Other than the market forces, central banks (RBI, in the case of India) also play a role in determining the exchange rate.

What are the factors determining the supply and demand of currency?

Balance of Payment determines how many rupees was demanded by the rest of the world and how much foreign currency was demanded by Indians. The BoP is divided into— current, capital, and financial accounts.

  • The current account is used to mark the inflow and outflow of goods and services into a country.
  • The capital account is where all international capital transfers in assets are recorded.
  • In the financial account, international monetary flows related to investment in the business, real estate, bonds, and stocks are documented.

The following 2 scenarios will clear the Rupee’s exchange rate fluctuations

First, India imports 80% of its oil. In case the demand or price of oil goes up, India will need more dollars to buy crude oil in the international market. On the other hand, the demand for Indian rupees has not increased. This would weaken the Indian Rupee exchange rate due to the increasing trade deficit.

Second, if the US central bank raises its interest rates, Global investors would start investing their money in the US, instead of India. Again, the rupee would weaken. Such a transaction would be recorded in the Capital Account.

What is RBI’s role in exchange rate determination?

RBI plays a very important role in exchange rate determination. It controls the drastic fluctuations in Rupee’s exchange rate. For that, RBI can take various measures:

In case of a drastic fall in Rupee value, RBI sells some of the dollars from its forex reserves. This is why the RBI’s forex reserves have gone down sharply since the war in Ukraine started in February.

In case of a drastic rise in Rupee value, the RBI buys excess amount of dollars (by paying rupees in the market) and adds it to its forex reserves.

Source: This post is created based on the article “Explained: Making sense of exchange rate” published in Indian Express on 11th May 2022.

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