Currency Exchange Rate | Exchange Rate System
Exchange Rate (XR)
It refers to the value of 1 currency as expressed in units of another currency. It is the price that one has to pay to purchase one unit of currency by making a payment in another currency.
There are 2 ways of expressing exchange rate –
Direct Quote
1$=80 ₹
1 unit of foreign currency in equivalent unit of domestic currency.
Indirect Quote
1₹ = 1/80$
1 unit of domestic currency in equivalent units of foreign currency.
Read a complete guide about International Organisations here.
Since XR is price, it is a function of demand and supply.
Demand of dollars
Following activities creates a demand for dollar
- Importers demanding $ for foreign payments
- Foreign investors withdrawing their investment from India
- Indians investing abroad
- Remittance from Indians to Rest of the world
- Indian tourists going abroad
- Factor Incomes sent from India (Int and profit)
Supply of dollars
- Exporters earning revenue
- FDI and FII in India
- Foreign tourists in India
- Remittances/Transfers received
- Borrowings from abroad etc.
Exchange Rate Systems (XRS)
Floating exchange rate system(XRS) – Market based XRS
XR is market determined if the demand and supply is market determined. There is no intervention by any authority such as the government, central bank, and the demanders and suppliers are free to demand or supply dollars at any given exchange rate. Since demand and supply continuously charges, therefore XR constantly fluctuates.
Fixed exchange rate system (XRS)
In it the demand and supply are controlled by an authority based on a fixed XR set. The government or the central bank may have certain objectives – economic or/and strategic, which they would like to achieve – via the exchange rate. As such they fix it at a particular value, and then maintain it by interfering in the market i.e. by influencing the demand and supply.
For ex- the govt may fix XR at 1$=60₹ and at this value the market demand may be greater than market supply As such the price of dollar would have a tendency to move up. The govt would then either curtail the demand such as by restricting imports of certain items, or augment supply such as by selling from reserves
As such fixing an XR is not merely setting a value of currency but it is about capability to enforce that value by interference in the market. Often the government take recourse to demand side measures as their capability to augment supply is limited.
Floating exchange rate/ Managed float/ dirty float
It is a system of exchange rate in which exchange rate is allowed to be determined on the basis of market forces except under some predefined conditions when the government or Central Bank may intervene. This intervention is only in the cases where some objectives supposed to be met with xrs are seen to get compromised. Various countries have defined various conditions of interference such as
- When exchange rate breaches particular limit
- When it breaches a predefined range in the basis of percentage movement (Volatility based intervention)
India follows mixed exchange rate system where RBI targets volatility.
Pegged XRS
Pegged is the same as fixed XRS – a country fixes i.e pegs its currency to some foreign currency. It is a system which is commonly used by those countries where forex markets have not yet properly developed. As such the country pegs its currency to some foreign currency, and then the value of the home currency with respect to other currencies gets determined in the same way as the value of currency to which it is pegged to. ex-Bhutanese currency to Indian Rupees, Jamaican $ to American $ etc.
