Q. Which of the following statement about factors affecting exchange rate system is not correct?

[A] RBI purchases dollars when Indian rupee depreciates.

[B] An increase in inflation rate can increase the demand for foreign currency.

[C] Higher interest rates can lead to the inflow of foreign currency.

[D] An increase in imports, depreciates domestic currency.

Answer: A

Explanation: Factors Affecting the Exchange Rate of India:

Intervention of The Reserve Bank of India: During high volatility in the exchange rate, RBI intervenes to prevent the exchange rate going out of control.

  • For example, the RBI sells dollars when Indian rupee depreciates too much, while it purchases dollars when the Indian rupee appreciates beyond a certain level.

Inflation rate: The increase in inflation rate can increase the demand for foreign currency which can negatively impact the exchange rate of the national currency.

  • For example, an increase in the inflation level of petroleum oil can increase the demand for foreign currency leading to the depreciation of Indian rupee.

Interest rate: Interest rates on government securities and bonds, corporate securities etc affect the outflow and inflow of foreign currency.

  • If the interest rates on government bonds are higher compared to other country forex markets, it can increase the inflow of foreign currency, while lower interest rates can lead to the outflow of foreign currency. This affects the exchange rate of Indian rupee.

Exports and imports: Exports and imports affect exchange rate as exports earn of foreign currency while imports require payments in foreign currency.

  • Thus, if the overall exports increases, the national currency appreciates, while an increase in imports leads to the depreciation of the national currency.
  • Apart from above, the Indian foreign exchange market is also affected by factors such as the receipts in the accounts of exports in invisibles in the current account, inflow in the capital account such as FDI, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities etc.

Source: https://blog.forumias.com/explained-making-sense-of-exchange-rate/