Foreign Exchange Rate
How exchange rates are determined under fixed, flexible, and managed float systems.
Definition
The foreign exchange rate is the price of one country's currency expressed in terms of another country's currency, determined in the foreign exchange market by the demand for and supply of foreign currency.
Simple Explanation
It is simply the 'price tag' of one currency in terms of another — how many rupees it takes to buy one US dollar, for instance.
Detailed Explanation
Under a flexible (floating) exchange rate system, the rate is determined purely by demand and supply of foreign exchange, just like the price of any good, with no government intervention. Under a fixed exchange rate system, the central bank commits to a specific rate and intervenes by buying/selling foreign currency to maintain it. Most economies today, including India, follow a managed float — largely market-determined, with occasional RBI intervention.
Demand for foreign exchange arises from imports, outward foreign investment, and other payments to foreigners; supply arises from exports, inward foreign investment, and remittances. Demand for foreign currency slopes downward (a cheaper dollar means importers buy more), and supply slopes upward, exactly like ordinary demand-supply analysis.
Depreciation (a currency falling in value) makes a country's exports cheaper and imports costlier in foreign-currency terms, generally boosting exports and curbing imports over time, while appreciation has the opposite effect.
It is important to separate two related but distinct terms tested often in exams: devaluation is a one-time, deliberate, official reduction in the value of a currency under a fixed exchange rate system (a policy decision), while depreciation is a continuous, market-driven fall in value under a flexible or managed system (no single authority decides it). Their effects on trade are similar, but the cause and the system in which each occurs are different.
The foreign exchange market connects directly back to the Balance of Payments: a current account deficit means a country demands more foreign exchange (for imports) than it earns (from exports), which by itself would push the domestic currency to depreciate — unless offset by capital account inflows or RBI intervention using its reserves. This is why a country's exchange rate, its BoP position, and its reserve levels must always be read together rather than in isolation.
Real-life Examples
Depreciation boosting exports
If the rupee depreciates from ₹80/$ to ₹85/$, an Indian software company's $1,000 invoice now fetches ₹85,000 instead of ₹80,000 — exports become more attractive in rupee terms.
Oil imports and the rupee
A rise in India's oil import bill increases the demand for US dollars, pushing the rupee's value down — i.e., the rupee depreciates.
Step-by-step Graph
- 1
Draw the forex market axes
Plot the exchange rate (Rupees per Dollar) on the Y-axis and quantity of foreign exchange on the X-axis.
- 2
Plot demand for forex
Draw a downward-sloping demand curve for dollars — a costlier dollar reduces the quantity demanded for imports.
- 3
Plot supply of forex
Draw an upward-sloping supply curve for dollars — a costlier dollar (in rupee terms) raises export earnings, increasing quantity supplied.
- 4
Find equilibrium
The intersection of demand and supply gives the equilibrium, market-determined exchange rate under a flexible system.
Formulas
Percentage Depreciation/Appreciation
% change = ((New rate − Old rate) / Old rate) × 100
Measures how much one currency has weakened or strengthened against another, expressed in units of the home currency per unit of foreign currency.
Tables
| System | Who determines the rate | RBI's role |
|---|---|---|
| Fixed | Government/central bank | Actively buys/sells to maintain the fixed rate |
| Flexible (floating) | Market demand and supply | No intervention |
| Managed float | Mainly market, partly authorities | Occasional intervention to curb excess volatility |
Common Mistakes
- Mixing up depreciation (a market-driven fall in value) with devaluation (a deliberate, official reduction under a fixed system) — they are not the same.
- Assuming depreciation always benefits the economy — it can also raise the cost of essential imports like crude oil, fuelling inflation.
- Drawing the demand for foreign exchange as upward sloping — it should slope downward, like ordinary demand.
Board Exam Tips
- Always specify the exchange rate system (fixed/flexible/managed float) before explaining how a rate is determined.
- Use precise terms — 'depreciation' for market-driven changes under a flexible system, 'devaluation' only under a fixed system.
- Link an exchange rate change to its effect on exports and imports explicitly when answering application-based questions.
Summary
- The exchange rate is the price of one currency in terms of another.
- Flexible rates are market-determined; fixed rates are officially maintained.
- India follows a managed float system.
- Demand for foreign exchange slopes downward; supply slopes upward.
- Depreciation cheapens exports and raises the cost of imports, and vice versa for appreciation.
Practice MCQs
1. Under a flexible exchange rate system, the rate is determined by:
2. A fall in the value of the rupee against the dollar, driven by market forces, is called:
3. The supply curve of foreign exchange typically slopes:
4. A deliberate, official reduction in the value of a currency under a fixed exchange rate system is called:
5. Which of the following increases the demand for foreign exchange in India?
6. India's exchange rate system today is best described as a:
Previous Year Questions
Distinguish between a fixed exchange rate system and a flexible exchange rate system.
Explain how depreciation of the domestic currency affects exports and imports.
Devaluation of a currency occurs under a: (a) Flexible exchange rate system (b) Fixed exchange rate system (c) Managed float (d) Gold standard
The demand curve for foreign exchange slopes: (a) Upward (b) Downward (c) Vertically (d) Horizontally
Explain the determination of the equilibrium exchange rate under a flexible exchange rate system, with a diagram.
Distinguish between depreciation and devaluation of a currency.
What is a managed floating exchange rate system? Explain with reference to India.
Explain any two factors that determine the demand for foreign exchange.
How does a rise in foreign exchange reserves affect the exchange rate under a managed float?
Explain the merits and demerits of a fixed exchange rate system as compared to a flexible exchange rate system.