Exchange Rate

The exchange rate is the price of one currency in terms of another currency. For instance, an exchange rate of approximately 75 rupees for $1 US in mid-2020 means that one US dollar could be exchanged for 75 Indian rupees. In 1991, the exchange rate was less than 20 rupees, but the significant difference is attributed to the shift from a system where the RBI arbitrarily set exchange rates to the current system where market forces play a crucial role in determining exchange rates.

Factors Influencing Exchange Rates:

The exchange rate of a currency is influenced by a multitude of factors, reflecting the complex dynamics of the global economic environment. Some key factors include:

1. Economic Growth:
• The overall growth rate of the economy is a fundamental determinant. A higher growth rate tends to attract foreign investment and positively impacts the currency's value.
2. Future Economic Potential:
• Investors often consider a country's future economic potential and prospects. Expectations of robust economic performance can attract foreign capital, strengthening the currency.
3. Foreign Trade Profile:
• The balance of trade, including import dependency, plays a crucial role. A trade surplus can contribute to currency appreciation, while a trade deficit may lead to depreciation.
4. Inflation:
• Inflation rates impact currency values. Lower inflation is generally associated with currency appreciation, while higher inflation may lead to depreciation.
5. Forex Reserves:
• The level of foreign exchange reserves held by the central bank, such as the Reserve Bank of India (RBI), can influence the currency's stability and investor confidence.
6. Interest Rates:
• Interest rates in a country affect its currency's attractiveness to investors. Higher interest rates can attract foreign capital, supporting currency strength.
7. Monetary Policies:
• The monetary policies of major economies, such as the United States, can have a significant impact. Changes in interest rates and other policy measures can influence currency values.
8. Currency Manipulation:
• Actions by major trading partners, like China, engaging in currency manipulation can indirectly affect other currencies. Countries may adjust their own currency values to remain competitive.
9. Commodity Prices:
• Fluctuations in international commodity prices, especially for key exports or imports, can influence a country's currency value.
10. External Debt Levels:
• The level of external debt, particularly short-term commercial debt, can impact investor confidence and influence exchange rates.
11. Twin Deficits:
• Fiscal and external current account deficits contribute to concerns about a country's economic stability, potentially leading to currency depreciation.
12. Political Stability:
• Political stability is a crucial factor influencing investor confidence. Political uncertainties may lead to currency depreciation.

Rupee Exchange Rate Mechanism:

The Indian rupee operates in a fully floated exchange rate system. The RBI engages in buying and selling foreign currency to facilitate normal operations related to foreign trade and debt servicing. While the exchange rate is not actively managed by the RBI, interventions may occur to counteract potential market manipulations that could destabilize the currency. The significant forex reserves, reaching about $585 billion by 2021, serve as a war chest to maintain stability in the forex market.