Context: The Indian Rupee has been weakening in value relative to the US Dollar, for a long time. INR’s exchange rate against USD breached the 85 mark last week, i.e., now $1 = Rs 85.
Relevance of the topic:
Prelims: Exchange rate- different contexts
Mains: Factors affecting exchange rate
What is the Exchange Rate?
- Exchange rate is the value of one currency relative to another currency.
- It is the rate at which one can swap currencies of different countries. For instance, how many rupees would buy you a dollar or a euro.
- Presently, one would have to pay Rs 85 to buy $1.
What decides the Exchange Rate?
- Demand for a particular currency decides its value relative to other currencies in the currency market.
- If Indians demand more US dollars than Americans demand Indian Rupee, the exchange rate will tilt in favour of the US dollar.
Factors deciding demand for Rupee vis-à-vis Dollar:
- Trade of Goods and Services: For sake of simplification, consider the case of only 2 countries- India and the US.
- Investments:
Factors deciding direction of Trade and Investments:
- Foreign trade policy:
- Suppose the US decides to cut imports from India, demand for Indian rupees will fall. This will cause rupee depreciation.
- High rate of inflation:
- In the scenario where India is having an inflation rate of 6%, an American investing in India with the expectation of 10% returns annually, will ultimately get only 4% returns.
- Comparatively, US markets would be more rewarding, because of less rate of inflation there.
- This will cause pull out of investments from India, and fall of demand for rupees.