Exchange Rate

In News: The rupee fell to an all-time low and is currently at 77.20 to the American dollar

What does exchange rate signify?

The rupee’s exchange rate vis-a-vis a particular currency tells us how many rupees are required to buy that particular currency
If the rupee’s exchange rate “falls”, it implies that buying American goods would become costlier.
At the same time, Indian exporters may benefit because their goods now are more attractive (cheaper) to the American customers.

How is the exchange rate determined?

In a free-market economy, the exchange rate is decided by the supply and demand for rupees and dollars.
However, in India, the exchange rate is not fully determined by the market.
From time to time, the RBI intervenes in the foreign exchange (forex) market to ensure that the rupee “price” does not fluctuate too much or that it doesn’t rise or fall too much all at once

What determines the rupee’s demand and supply vis-a-vis other currencies?

The Balance of Payment is essentially the overall ledger of how much rupee was demanded by the rest of the world and how much foreign currency (that is, currencies of all countries) was demanded by Indians.

BoP

Balance of Payment (BoP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.
It indicates whether the country has a surplus or a deficit on trade.
When exports exceed imports, there is a trade surplus and when imports exceed exports there is a trade deficit.

Components of BoP:

For preparing BoP accounts, economic transactions between a country and rest of the world are grouped under – Current account, Capital account and Errors and Omissions. It also shows changes in Foreign Exchange Reserves.

Current Account:

It shows export and import of visibles (also called merchandise or goods – represent trade balance) and invisibles (also called non-merchandise).
Invisibles include services, transfers and income.

Capital Account:

It shows a capital expenditure and income for a country.
It gives a summary of the net flow of both private and public investment into an economy

Foreign Exchange Reserves –

Overall the BoP account can be a surplus or a deficit.
If there is a deficit then it can be bridged by taking money from the Foreign Exchange (Forex) Account.
If the reserves in the forex account are falling short then this scenario is referred to as BoP crisis.
Thus BoP can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.

How does the rupee’s exchange rate fluctuate?

Exports and imports – affect exchange rate as exports earn of foreign currency while imports require payments in foreign currency.
Interest rate – on government securities and bonds, corporate securities etc affect the outflow and inflow of foreign currency; the US central bank raises its interest rates and looks set to raise them further in the future
Intervention of the Reserve Bank of India
Inflation (crude oil prices go up sharply)

What is the RBI’s role in this?

To soften the rupee’s fall, the RBI would sell in the market some of the dollars it has in its forex reserves.
This will soak up a lot of rupees from the market, thus moderating the demand-supply gap between rupee and dollars.
The eventual impact of a fall depends on several factors. For instance, a fall can help India’s exporters — unless they importing raw materials, which would become costlier.

Previous Year Questions (PYQs)

Q.1) Consider the following statements:

The effect of devaluation of a currency is that it necessarily

Select the correct answer using the code given below :

Q.2) In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis?

Select the correct answer using the code given below :

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