What is the exchange rate and why the value of the rupee fluctuates against the US dollar
Fluctuations in the value of the rupee against the dollar are a daily occurrence. The value of the rupee, like any other currency, changes almost daily. This concept of currency fluctuation is part of the larger forex market. To understand the concept and process of the value of a currency, one needs to take a look at the forex market.
What is Change market?
The forex market is simply a global market where currency trading takes place. This market is decentralized in nature.
Simply put, one currency is exchanged with another currency at a particular rate. The rate at which two particular currencies are exchanged is called the exchange rate.
The exchange rate is the value of a country’s currency against the currency of another country.
The exchange rate of a country’s currency does not remain constant, but rather continues to change. Hence, the changing value of the Rupee remains a constant part of our daily news.
For example, the exchange rate of Indian rupee against US dollar is about 1 US dollar = 74.12 Indian rupee. This means that if you want to buy a dollar on the forex market using Indian rupee, you will need 74.12 rupees.
How is the value of a currency determined?
In most countries of the world, the value of currency is determined by floating exchange rates. In this system, the value of a currency is determined by the basic economic concept of demand and supply.
A currency with more demand has a higher value. As the exchange of different currencies takes place in the forex market, the demand for each currency in the market determines its value.
In this process of determining value, a country’s government or authority has little or no control. Even if the government or the central bank of the country concerned intervenes when the currency becomes destabilized or behaves badly.
But overall, it is the mechanism of demand for a particular currency that determines its value.
There is another system for determining the value of currencies, although it is not as widespread as the one above. This is called the indexed trading system.
Here, the value of a currency of a country is fixed with a particular currency.
For example, a country decides to fix the value of its currency against the US dollar and determines its currency at â of a dollar.
How do currencies evolve?
Most currency exchanges take place in banks. Currencies issued by different countries pass through banks and this is where most transactions take place.
A person in Delhi with legal US dollar banknotes can have them converted to Indian rupee at a particular exchange rate at a bank. This bank represents a small unit in the huge foreign exchange market.
A country’s central bank (RBI in India) also maintains a large reserve of foreign currency to deal with any kind of local currency problems in the forex market. As mentioned earlier, the authorities of a country intervene when they feel a bad time for their currency.
They do this by adjusting the supply of a particular currency either directly or by changing other factors. As stated earlier, it is supply and demand that determine the value of a currency. Since demand control is hardly in the hands of authority, they influence the value of a currency by adjusting the supply of a currency in the market.
American dollar in the Indian rupee market
Demand for the US dollar is high as India imports more products from the United States than it exports. In such a scenario, the demand for US dollar will increase as more dollars will be paid to the United States while purchasing goods from them.
And on the Indian side, it will be necessary to buy more dollars on the foreign exchange market to pay for these goods.
As such, the demand for US dollars will increase against the Indian rupee and hence their value. But if the value of the Indian rupee drops much, the government will intervene.
Immediately, they will try to reduce the supply of Indian rupees (to compensate for the low demand). They will buy the Indian rupee in the market using the US dollar reserves it holds.
As it buys more Indian currencies using US dollars, the supply of Indian currencies decreases while that of the United States increases, leading to an increase in the value of the rupee and a decrease in the value of the dollar. They can also influence the offer by using other techniques.
In the long run, to keep a currency at a good value, a country must increase the demand for its currency. This is a small example of the process, the actual process works on a larger scale and on multiple levels.
Ultimately, it’s the demand for a particular currency that determines its long-term value. And this demand is influenced by many factors such as a country’s fiscal and monetary policies, the volume of trade in a country, inflation, people’s confidence in the political and economic conditions of a country.