Exchange rate determination of indian currency ??

Question

How exchange rate of indian currency is determined. What are the practical factors that affect the exchange rate. How indian currency rate goes up and comes down (with respect to US dollar)
and what are the practical reasons behind it. How bank deals with foreign exchange and how RBI interfere in it ?

Answer 1

Long back the exchange rate of Indian Rupee (now referred to as INR) vis a vis other currencies was an administered or controlled exchange rate. However with the opening of the economy and the Rupee being made convertible completely on current account transactions and substantially on capital account transactions the exchange rate between USD and INR is market determined.

The movements in the exchange rates between the two currencies depend on the demand and supply of that currency. When imports are being paid normally in USD, there is demand for USD and when export payments are received the supply of the USD is increased. Again forein investment inflow of USD will increase the supply while outward investments, remittance of dividends etc will increase the demand for USD.

Normally when the imports of a country are higher than its exports, there is net pressure on supply and the foreign currency tends to be stronger.

On any given day if foreing institutional investors pump in foreign money to purchase the stocks in the bullish stock markets the supply suddenly goes up and demand being constant, the rupee goes strong. In case of sudden withdrawal of investments for profit booking by the FII, the USD will become strong on account of the same reasons.

RBI normally intervens only to prevent volatile short term fluctuations which are based more on sentiments than on economic grounds.

Answer 2

THE exchange rate of a sovereign country’s currency vis-a-vis others’ depicts the monetary-value nexus between their goods and services. The current rupee rate against one euro, for instance, varies between Rs 43 and Rs 44. A dearer euro would imply a rupee exchange rate nearer to Rs 44 (say Rs 43.53) while a cheaper euro would lower it (to say Rs 43.23).

What are the factors that determine valuation of currency?
The valuation of printed currency has always been of concern. The practice, before World War I, had been to link it to the sum of bullion held by the treasury (the so-called ‘gold standard’). Net exporting econo-mies, accumulating forex (often as gold), would then find their currency’s value rising; those with deficits would undergo the opposite. Meanwhile, currency and trade were private sector prerogatives, with official treasuries making requisite adjustments in terms of money supply (or coinage).

World War I and the Great Depression (1929) changed all that. The US and European economies all began experiencing increases in variance across inflation rates. That led Gustav Cassel, an economist of that era, to posit that exchange rate changes should account for differences in inflation rates. To him, terms like ‘undervaluation’, or ‘overvaluation’ were just a layman’s way of saying that the going value of the exchange rate is inconsistent with the relationship that the domestic price level has with (comparable) prices ruling in a country’s major trading partners. Cassel’s ‘purchasing power parity’ (PPP) approach for determining a currency’s ‘correct’ exchange rate was, thus, an attempt to devise a way for governments to set equilibrium currency values if they again wanted to peg to gold.

Market forces yielded place to ‘policy-making’ when PPP was followed by the ‘elasticities approach’ to balance of payments. That debunked devaluations, saying they would hardly help if the domestic demand for importables remained inelastic in the devaluing economy, while the demand for exportables in importing economies was price-inelastic too. The devaluing economy would then be left importing unchanged quantities — but at higher local-currency prices — while its exports (also unchanged) would cost less and fetch lesser amounts of foreign exchange! Hence was born the ‘elasticity pessimism’ doctrine. The policy prescription for avoiding such an impasse was that devaluing governments should also cut money supply to quell internal demand (or, ‘absorption’) to enlarge exportable surpluses. That was the ‘absorption’ approach to exchange rate determination. Policy-makers then had to either adopt the hard way of implementing a contractionary monetary policy by deflating the economy, or do just the opposite — and keep supporting demand and continue running up current-account deficits.

Answer 3

Mainly supply and demand.

Most News paper will show the day by day rate, as best I can remember it fluctuates between Rs. 46.00 and Rs. 50.00 to a $1.00.

RBI may interfear by dumping the Rs. or by Dumping other currency.

At one time Rs. was supported by Indian Government, exchange rate was around Rs. 10.(1980) Before that it was around Rs. 2.50 (1946) at that time it was supported by British Goverment.

Answer 4

The process is really not different in its essentials from the way any market functions. The supply and demand for different goods determine what their prices are.