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Definition: Exchange rate is the price of one currency in terms of another currency.

Description: Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of a country whereas floating exchange rates are decided by the mechanism of market demand and supply.

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.

Types of Exchange Rate

Fixed Exchange Rate

The rates that are directly convertible towards other currencies are called fixed rate. Also, in case of a different currency, there is a currency board arrangement where it is backed by the domestic currency against one to one foreign reserves.

The countries falling under this have abandoned their own currency in favor of other country’s currency. Also, they have very small bands which are less than 1%.

Floating Exchange Rate

The most common regime today that is adopted in most countries are floating exchange rates. Mostly used yen, dollar, Euro, and British pound are the different types of currencies that fall under this category.

Also, in this case, central banks of the respective countries intervene frequently in order to avoid deprecation or appreciation. These regimes are many times managed float or dirty float.

Pegged float – These types of currencies are pegged against some value or bands. They are adjusted either periodically or fixed. Pegged floats are also considered as crawling bands.

Crawling band is the rate at which it is allowable to fluctuate around a central value in a band. Also, this is adjusted periodically. So, it is done in a controlled way or at a preannounced rate. Both of these follow certain economic indicators.

Crawling pegs are the rate that is in itself fixed. It is adjusted as mentioned above. When the rates are pegged at horizontal bands than the band is allowed to fluctuate bigger than 1% although in a fixed rate. This fluctuation happens around the central rate.

Dollarization

Dollarization is a term used when the citizens of a country use foreign currency in relation to their own currency. This term is not only correlated to US dollars. It is used generally when one uses foreign currency as a national currency. One of the best examples of this is Zimbabwe.

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.
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