Exchange rate

1. Meaning, quotations and basic distinctions

The exchange rate enables payments between economies using different currencies. In India, the rupee–US dollar rate is commonly expressed as rupees required to purchase one dollar. This is a direct quotation from an Indian resident’s perspective: domestic currency per unit of foreign currency. An indirect quotation expresses foreign currency per unit of domestic currency. Always identify the quotation before interpreting a numerical increase.

If the rate moves from ₹80/$ to ₹84/$, the dollar becomes costlier and the rupee depreciates. At ₹76/$, the rupee has appreciated relative to ₹80/$. Exchange rates are relative prices: rupee depreciation against the dollar simultaneously means dollar appreciation against the rupee. The rupee can depreciate against one currency while appreciating against another.

Under a fixed exchange-rate arrangement, an official reduction in the currency’s external value is devaluation; an official increase is revaluation. These terms should not automatically be used for ordinary market fluctuations. Currency redenomination, such as replacing old notes with new units at a prescribed ratio, is also different: it does not by itself change real purchasing power or international competitiveness.

• Spot rate: the exchange rate for a transaction settled according to the market’s standard near-term settlement convention.
• Forward rate: a rate agreed today for exchanging currencies at a specified future date.
• Cross rate: an exchange rate between two currencies derived using their respective rates against a third currency.

2. How exchange rates are determined

In a floating system, exchange rates emerge from demand and supply in the foreign-exchange market. Indian importers, residents travelling abroad and investors acquiring foreign assets generally demand foreign currency. Export receipts, remittances and inward investment can supply foreign currency when converted into rupees. A rise in demand for dollars relative to supply tends to weaken the rupee, other things remaining equal.

Important influences include inflation differentials, interest-rate differentials, productivity, trade conditions, capital flows and expectations. Persistently higher Indian inflation relative to trading partners may weaken the rupee over time. Higher domestic interest rates may attract capital, but not necessarily: investors also consider expected depreciation, risk, taxes and liquidity. Global risk aversion can trigger portfolio outflows even when domestic interest rates are relatively high.

Purchasing power parity links exchange rates to relative price levels. Relative PPP suggests that a higher-inflation country’s currency tends to depreciate over the long run. It is not a reliable short-run prediction because transport costs, non-traded services, tariffs and capital flows matter. Covered interest parity instead links spot rates, forward rates and interest differentials through hedged arbitrage, subject to market frictions.

Balance-of-payments developments influence exchange rates, but a current-account deficit does not mechanically imply depreciation. Adequate capital inflows can finance the deficit and support the currency. Conversely, sudden capital outflows can weaken the currency despite improving merchandise exports.

• Oil-price increases can raise India’s import bill and dollar demand, though the final exchange-rate outcome depends on other flows.
• A stronger global dollar may weaken several currencies simultaneously; it need not indicate an exclusively domestic problem.
• Expectations of future policy or economic stress can move exchange rates before actual trade or investment transactions occur.

3. Exchange-rate regimes and India’s framework

A fixed regime commits the authorities to maintaining a parity against another currency or a basket. A floating regime allows market forces to determine the rate. Intermediate arrangements include crawling pegs, bands and managed floating. Maintaining a peg may require reserve intervention, interest-rate adjustments or restrictions on financial flows; it is not costless.

India’s exchange rate is market-determined, while the Reserve Bank of India intervenes to contain excessive volatility and maintain orderly market conditions, without announcing a fixed target level. Selling dollars and buying rupees can ease depreciation pressure and, other things unchanged, absorb rupee liquidity. Buying dollars supplies rupees and can restrain appreciation pressure.

Intervention changes domestic liquidity unless offset. Sterilisation means neutralising this liquidity effect through other monetary operations. For example, after purchasing foreign exchange, the RBI can absorb the resulting rupee liquidity through appropriate instruments. Intervention capacity is constrained by reserves, costs and broader monetary objectives.

The impossible trinity states that a country cannot simultaneously maintain a fixed exchange rate, completely free capital mobility and an independent monetary policy. India combines exchange-rate flexibility, monetary-policy autonomy and calibrated capital-account regulations. Current-account convertibility concerns payments for trade, services and other current transactions; capital-account convertibility concerns cross-border asset and liability transactions. Neither should be confused with a guarantee of a stable currency.

• The Foreign Exchange Management Act, 1999, replaced FERA and came into force on 1 June 2000.
• Current-account transactions remain subject to applicable restrictions and procedural requirements.
• Foreign-exchange reserves provide a buffer, but defending an exchange rate indefinitely against persistent pressure can be costly.

4. Nominal, real and effective exchange rates

A bilateral nominal exchange rate compares two currencies without adjusting for prices. A bilateral real exchange rate adjusts for relative price levels. With the nominal rate defined as domestic currency per unit of foreign currency, one common formula is q = E × P foreign / P domestic. Under this convention, an increase in q indicates real depreciation. Always check the definition, because alternative conventions reverse the interpretation.

The nominal effective exchange rate, or NEER, is a weighted index of a currency against a basket of partner currencies. The real effective exchange rate, or REER, adjusts NEER for relative prices. RBI publishes trade-weighted indices, including 6-currency and 40-currency series. Unlike the bilateral formula above, an increase in these RBI index values indicates appreciation.

REER helps assess changes in price competitiveness. If Indian inflation exceeds partner-country inflation, the rupee may appreciate in real terms even while remaining nominally unchanged. It may also depreciate nominally but appreciate in real terms if the inflation differential more than offsets that depreciation. An REER above 100 indicates appreciation relative to its base-period benchmark, not definitive proof of overvaluation relative to an equilibrium exchange rate.

• NEER measures basket-based nominal currency movement; REER adds relative inflation.
• A bilateral rupee–dollar movement may differ from movement against the overall trading-partner basket.
• Competitiveness also depends on productivity, quality, logistics and market access, which REER does not fully capture.

5. Economic effects and examination applications

Depreciation raises the rupee cost of foreign-currency-priced imports, other things unchanged. Petroleum, fertilisers, machinery and electronic components may become costlier, potentially transmitting imported inflation. Foreign education and overseas travel also become more expensive. Conversely, recipients of a fixed dollar remittance receive more rupees.

Exporters may gain because their goods become cheaper in foreign-currency terms or their foreign-currency earnings convert into more rupees. However, gains depend on invoicing, demand, contracts, production capacity and imported-input intensity. A firm importing costly components may gain much less than a labour-intensive exporter using mainly domestic inputs. Borrowers with unhedged foreign-currency liabilities face higher rupee repayment burdens.

Depreciation does not guarantee an immediate trade-balance improvement. Under standard assumptions, the Marshall–Lerner condition requires the sum of the absolute price elasticities of export and import demand to exceed one. Existing contracts and slow quantity adjustments may initially worsen the balance before improvement, producing a J-curve pattern; this is a possibility, not a universal outcome.

Hedging reduces exchange-rate exposure through instruments such as forwards, futures and options. An importer can lock in the future rupee cost of dollars using a forward contract. Hedging provides predictability rather than guaranteed additional profit. For examination questions, separate immediate accounting effects from uncertain behavioural responses and avoid claims that depreciation is always beneficial or appreciation always harmful.

• Appreciation can lower import costs and imported inflation but may squeeze exporters’ price competitiveness.
• Depreciation redistributes gains and losses; its net effect depends on the economy’s trade structure and balance sheets.
• A foreign investor’s return depends on both the domestic asset return and the exchange-rate change.

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