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What Is Currency Exchange Rate And How Does It Work?

by Shatakshi Gupta

We often hear in the news that the value of Rupee has fallen or increased. But, did you know what does it mean or how it works or what are its effects on our economy? Well, most of us don’t know all these things. Today, in this article, we discuss about the exchange rate of any currency and some related aspects.

What is an exchange rate?

The currency exchange rate refers to the price of a unit of foreign currency in terms of the domestic currency. For example, if we have to pay 75 rupees to get one dollar, then the exchange rate will be 75 rupees per dollar. You must understand that the currency exchange rate often determines the ability to buy and sell at the international level.

The currencies of strong economies are generally very strong.  The exchange rate of any currency is determined by the interaction of its demand and supply. For example, if more and more Indians want to buy American goods, the demand for the US dollar will be higher than the rupee, which in effect will make the US dollar stronger than the rupee. On the other hand, if there is an increase in the demand for the Indian rupee, the Indian rupee will become stronger than the US dollar.

However, in several instances, the central bank of a country intervenes to control the excessive fluctuations in the exchange rate. But the excessive intervention of the central bank or the government in the economic world is not considered appropriate.

We generally see the value of the Rupee with respect to US Dollar, but America is not the only country in the world, India does international trade with many other countries besides the USA, thus for a better understanding of the Indian economy, it is necessary that we also see that Rupee interacts with other trading partners of India.

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How do we check the actual strength of the Rupee?

The Reserve Bank of India (RBI) tabulates the Nominal Effective Exchange Rate or NEER of the rupee with respect to the currencies of 36 trading partner countries. It is a type of weighted index, that is, in this, more importance is given to those countries with which India does more business.

 A decrease in this index reflects a depreciation in the value of the rupee, while an increase in the index reflects an appreciation in the value of the rupee.

Apart from NEER, the Real Effective Exchange Rate or REER is also an important parameter to measure the changes taking place in the Indian economy.

 Under REER, apart from other factors included in NEER, domestic inflation in various economies is also taken into account, due to which this becomes a more reliable parameter.

Relation between Exchange rate and inflation:

Many factors affect the exchange rate of any currency like interest rate and political stability. The most important of these factors is inflation.  For example, let’s say that the exchange rate of the rupee in the current year is Re 10 per dollar.

 Thus we can get 10 US dollars for 100 rupees. But if next year inflation in the Indian economy remains 10 per cent and inflation in the US economy remains zero, then to get the same 10 US dollars in the next year, we need Rs 110.

Read more: What Are Nostro And Vostro Bank Accounts?

Depreciation/ Devaluation and Appreciation/ Revaluation:

There are mainly two types of exchange rate systems, i.e, fixed exchange rate system and floating exchange rate system.

Under the fixed exchange rate system, the government fixes a level of the exchange rate at a particular rate. In contrast, under the floating exchange rate system, the exchange rate is determined independently by the market forces.

The concept of currency depreciation and its appreciation pertains to countries with a floating exchange rate system. In a floating exchange rate system, a currency depreciates when the supply of money in the market increases while its demand continues to fall.

 Whereas currency appreciation means an increase in the value of one currency in relation to other foreign currencies.  Appreciation of a currency occurs when the supply of money is less than its demand in the foreign exchange market.

In a fixed exchange rate system, when the government intentionally makes its currency cheaper to boost export, it is called currency Devaluation. Conversely, when the government makes its currency dear, it is called currency Revaluation.

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