An exchange rate is a rate at which one currency is exchanged for another currency. It guides movement of money between countries in terms of trade and investments. In India, foreign exchange market is governed under the Foreign Exchange Management Act (FEMA), 1999. It is more liberal and facilitatory with an emphasis on foreign exchange facilitation. FEMA, 1999 replaced the Foreign Exchange Regulation Act (FERA), 1973 which was more regulatory and prohibitive in nature.
Factors influencing exchange rates
1. Inflation differential: The difference in inflation between two countries under consideration affects the exchange rate. Generally, higher rate of inflation leads to depreciation of currency. This is because when inflation is high, the purchasing power of currency goes down.
2. Interest Rates: An increase in interest rates in the domestic economy leads to appreciation of currency. This is because foreign investors find it attractive to put money in the country with higher interest rates. However, it is to be noted that only those who do fresh investment get the benefit.
3. Public Debt: Higher government borrowing leads to depreciation of currency as liquidity in the system increases since higher government expenditure is coupled with inflation.
4. Current Account Deficit: Higher CAD leads to currency depreciation.
5. Political Environment: A stable political environment signals a continuity in policies and a positive economic climate. This leads to confidence among foreign investors to put money in that country. This leads to appreciation of currency.
6. Balance of Payment situation: It signals the trade competitiveness of a nation. Higher exports and capital inflows lead to increase in foreign exchange reserves and appreciation of currency.
7. Speculation: The expectation-based trading in currency where there is a belief of appreciation in currency rate may lead to exchange rate fluctuation. If there is very high speculative demand, it may actually lead to appreciation of currency as currency is a tradable commodity.
Appreciation of Rupee
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- If the exchange rate of USD to INR moves from say, Rs 80 per USD to Rs 75 per USD.
- It leads to rupees becoming stronger than USD.
- Exports may fall with appreciation of Rupees. This is because from the perspective of importer who is located outside India, he/she will get lower units of items than what he/she was getting earlier for one dollar worth of imports (Earlier Rs 80 worth of goods were getting imported from India, now it is only Rs 75)
- It leads to imports getting cheaper. This is because for importing one USD worth of goods in India, now lower units of local currency (INR) would be used. Thus, from the perspective of importer who is located in India, it becomes cheaper to import same units of items.
Depreciation of Rupee
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- If it goes down from Rs 80 per USD to Rs 85 per USD.
- It leads to Rupees becoming weaker than USD.
- Exports are likely to increase as more goods can be purchased by US based buyers by exchanging his/her USD.
- It increases the import bill as import becomes expensive.
