Exchange Rates - All About to know | SBI PO Prelims & Mains Preparation - Bank Exams PDF Download

Introduction

How to calculate Exchange rate?

• It is calculated by relating the value of one currency to other country currency
• In mathematical terms, Exchange rate = (price of domestic currency)/(price of foreign currency)
• Example: $1 = 65 rupees implies that one has to give 65 rupees to get $1

Who determines Exchange rate?

• After World War II, World Bank and IMF were formed to reconstruct the war-torn world nations
• IMF determined the exchange rate initially with the quota of the developed nations
• Later, UK withdraw from the fixed rate regime and fixed its own currency rate depending on market conditions
• Gradually, countries also started moving to the floating currency regime
• Currently, the central bank of nations have the power to determine the exchange rate by buying and selling currencies in the foreign exchange market

How to determine Exchange rate?

• Fixed exchange rate
• Floating exchange rate
• Crawling peg exchange rate

Fixed Exchange Rate

• Also called as pegged exchange rate
• Central bank of a nation fixes and maintains the exchange rate
• The domestic price of the currency will generally be set against US dollar or other world currency like Euro, Yen or IMF basket of currencies
• Central bank will sell and buy its own currency from the foreign exchange market against the pegged currency
• RBI has been following the fixed exchange rate till 1991
• Now complete fixed exchange rate regime has come to an end and only a combination of fixed and floating rate are employed in the foreign exchange market

Floating Exchange Rate

• Floating exchange rate is determined by demand and supply prevailing in the market
• Rate determined solely by the market
• Exchange rate constantly changes periodically (even on daily basis)
• Also termed as the self-correcting exchange rate
• When the demand for a currency in foreign exchange market becomes low, then its imports become expensive and ultimately its value will decrease
• This will cause heavy demand for goods and services domestically
• This, in turn, results in the creation of more jobs domestically
• Thus an automatic correction is made balancing the demand and supply in the floating currency regime
• The exchange rate changes in global scenario will affect the domestic currency in the floating rate regime
• Currently, this is the widely accepted and adopted currency regime by the world nations

Crawling Peg Exchange Rate

• Also known as Dirty Floating rate
• This is a combination of fixed and floating exchange rate
• Government allows the currency to fluctuate freely in a given band determined by the central bank
• Once the currency exceeds the band fixed by central bank, Government intervenes in the foreign exchange market to stabilise the domestic economy

Implications of Exchange rate

• Appreciation of exchange rate or rupee appreciation implies rise in exchange rate of rupee
• Depreciation of exchange rate or rupee depreciation implies fall in exchange rate of rupee
• Both appreciation and depreciation of currency occurs as a result of change in supply and demand of the currency in the foreign exchange market
• Depreciation of currency favours exports and makes imports costlier
• Appreciation of currency favours imports and makes exports costlier
• Devaluation of currency is similar to depreciation of currency
• India devalued its currency during the 1991 Balance of Payment crisis
• Recently China devalued its currency Yuan
• RBI has the power to devalue the rupee by selling more rupees and buying dollars from the foreign exchange market
• Similarly, RBI can revalue the rupee by selling dollars and buying rupees
• The activities of devaluation and revaluation of currency are associated with the fixed exchange rate regime