Foreign Exchange Rate Determination
Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of foreign currency. According to Purchasing Power Parity theory, the foreign exchange rate is determined by the relative purchasing powers of the two currencies.
Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate between India and the USA will be (100/20=5), 1 $ = 5 Re.
Forces Behind Exchange Rate Determination
Foreign Exchange is a price of one country currency in relation to other country currency, which like the price of any other commodity is determined by the demand and supply factors. The demand and supply of the foreign exchange rate come from the residents of the respective countries.
| Demand for Foreign Exchange (Foreign Money goes out) | Supply of Foreign Exchange (Foreign Money Comes in) |
| Foreign Currency is needed to carry out transactions in foreign countries or for the purchase of foreign goods and services (IMPORTS). | The source of foreign currency available to the domestic country are foreigners purchasing our goods and services (Exports). |
| Foreign currency is needed to invest in foreign country assets/shares/bonds etc. | Foreigners investing in Indian Stock markets, Assets, Bonds etc. (FPIs and FDIs) |
| Foreign currency is needed to make transfer payments. Example: Indian Parents sending Money to his/her son/daughter studying in the USA. | Transfer payments. Example: Indian working in the USA, sending money to his/her old aged parents. |
| Indians holding money in overseas Banks | Foreigners holding assets in Indian Banks. |
| Indians Travelling abroad for Tourism Purpose. | Foreigners travelling to India. |
- The DD curve represents the demand for foreign exchange by India. The SS curve represents the supply of foreign exchange to India.
- The point where both DD and SS curves intersect is the point of equilibrium. At this point demand for foreign exchange is exactly equal to the supply of foreign exchange.
- At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
- In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in time, the exchange rate is at E1, then the demand for foreign exchange falls short of supply of foreign exchange, as a result at this point Indians are demanding less foreign currency due to which Re will appreciate vis-à-vis foreign currency. The appreciation mainly occurs due to a favourable balance of payment situation (Surplus).
- By the same token at point E2, demand for foreign exchange is greater than the supply of foreign exchange, at this point Indians are demanding excess foreign exchange than what the foreigners are willing to supply, as a result, at E2 Re will depreciate vis-à-vis foreign currency. The depreciation mainly occurs due to the unfavourable balance of payments situation(Deficits).
Types of Exchange Rate Regimes
- Fixed Exchange Rate versus Floating Exchange Rate
| Fixed Exchange Rate | Floating Exchange Rate |
| Under this system, there is complete government intervention in the foreign exchange markets. | Under this system, the market is allowed to determine the value of exchange rate freely. |
| The government or central bank determines the official exchange rate by linking exchange rate to the price of gold or major currencies like US dollar. | The exchange rate is determined by the forces of demand and supply. |
| If due to any reason, the exchange rate fluctuates, government intervenes and make sure that equilibrium pre-determined level is maintained. | If due to any reason exchange rate fluctuates, the government never intervenes and allows the market to function and determine the true value of exchange rate. |
| The only merit of fixed exchange rate system is that it assures the stability of exchange rate. It prevents both currency appreciation and depreciation. | The only demerit of floating exchange rate system is that exchange rate fluctuates a lot on day to day basis. |
| The many disadvantages of such a system are: It puts a heavy burden on governments to maintain exchange rate. This especially happens during the time of deficits, as the governments need to infuse a lot of money to maintain exchange rate.
The foreign investors avoid investing in such countries as they fear to lose their investments because they believe that exchange rate does not reflect the true value of the economy. |
The advantages of such a system are: the exchange rate is determined in well-functioning foreign exchange markets with no government interference.
The exchange rate reflects the true value of the domestic currency which helps in establishing the trust among foreign investor. A country can easily access funds/ loans from IMF and other international institutions if the exchange rate is market determined. |
- Managed Floating Exchange rate
Manage Floating exchange rate lies in between of the two extremes of fixed and floating exchange rate. Under such a system, the exchange is allowed to move freely and determined by the forces of the market (Demand and Supply). But when a difficult situation arises, the central banks of the country can intervene to stabilise the exchange rate.
There are mainly three sub categories under managed floating exchange rate:
- Adjusted Peg System: In this system, a country should try to hold on to a fixed exchange rate system for as long as it can, i.e. until the country’s foreign exchange reserves got exhausted. Once the country’s foreign exchange reserves got exhausted, the country should undergo devaluation of currency and move to another equilibrium exchange rate.
- Crawling Peg System: In this system, a country keeps on adjusting its exchange rate to new demand and supply conditions. The system requires that instead of devaluing currency at the time of crisis, a country should follow regular checks at the exchange rate and when require must undertake small devaluations.
- Clean Floating: In the clean float system, the exchange rate is determined by market forces of demand and supply. The exchange rate appreciates or depreciates as per market forces and with no government intervention. It is identical to floating exchange rate.
- Dirty Floating: In the dirty float system, the exchange rate is to a very large extent is determined by the market forces of demand and supply (so far identical to clean floating), but occasionally the central banks of the countries intervene in foreign exchange markets to smoothen or remove excessive fluctuations from the foreign exchange markets.
Note for Students
The Bretton Woods system of exchange rate which was in operation from 1944 till 1971, was one of relative fixed exchange rate as opposed to rigid fixed exchange rate. As a matter of fact, rigid fixed exchange rate as defined above, is never been used in history. Even under the system of Gold Standard 1870-1941, the exchange was relatively fixed and not rigidly fixed.
Exchange Rate Management in India
Over the last six decades since independence the exchange rate system in India has transited from fixed exchange rate regime where the Indian Rupee was pegged to the UK Pound to a basket of currencies during the 1970s and 1980s and eventually to the present form of market determined exchange rate regime since 1993.
- Par Value System (1974-1971): After Independence Indian followed the ‘Par Value System’ whereby the rupee’s external par value was fixed with gold and UK pound sterling. This system was followed up to 1966 when the rupee was devalued by 36 percent.
- Pegged Regime (1971-1992): India pegged its currency to the US dollar (1971-1991) and to pound (1971-75). Following the breakdown of Breton Woods system, the value of pound collapsed, and India witnessed misalignment of the rupee. To overcome the pressure of devaluation India pegged its currency to a basket of currencies. During this period, the exchange rate was officially determined by the RBI within a nominal band of +/- 5 percent of the weighted average of a basket of currencies of India’s major trading partners.
- The period since 1991: The transition to market-based exchange rate was in response to the BOP crisis of 1991. As a first step towards transition, India introduces partial convertibility of rupee in 1992-93 under LERMS.
- Liberalised Exchange Rate Management System (LERMS): The LERMS involved partial convertibility of rupee. Under this system, India followed a dual exchange rate policy, where 40 percent of the exchange rate were to be converted at the official exchange rate and the remaining 60 percent were to be converted at the market-based exchange rate. The exchange rate converted at the official rate were to be used for essential imports like crude, oil, fertilizers, life savings drugs etc. All other imports should be financed at the market-based exchange rate.
- Market-Based Exchange rate Regime (1993- till present): The LERMS was a transitional mechanism to provide stability during the crisis period. Once the stability is achieved, India transited from LERMS to a full flash market exchange rate system. As a result, since 1993, exchange rate fluctuations are marker determined. In the 1994 budget, 60:40 ratio was removed, and 100 percent conversion at market-based rate was allowed for all goods and capital movements.
By
Himanshu Arora
Doctoral Scholar in Economics & Senior Research Fellow, CDS, Jawaharlal Nehru University
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