BQ Learning: What Is An Exchange Rate? How Is It Determined?
This is a series of explainers to educate and inform watchers of the economy. In association with CRISIL as knowledge partner.
The exchange rate is the value of one currency compared with another. It changes through the trading day, each day.
But how is this rate determined? The answer is not as simple as it seems.
Some countries, through their central banks, set the price of the domestic currency at a particular level against the reference currency (usually the U.S. dollar, a global reserve currency). This is called a fixed exchange rate. For instance, the Hong Kong dollar is pegged to the U.S. dollar within a narrow trading band.
Other countries may let the price be determined by market forces — that is, demand for and supply of the currencies. This is called a floating exchange rate.
In India, the rupee is largely determined by market forces. The Reserve Bank of India’s stated role is to “maintain stability in the foreign exchange market… without targeting a pre-specified level or band for rupee’s exchange rate.”
Appreciation Vs. Depreciation
The exchange rate is said to depreciate if the domestic price goes up against the reference currency (for simplicity here, against the U.S. dollar).
For instance, if the rupee sees an increase in its exchange rate from 74.5/$ to, say, 75/$, it would mean we need to shell out more rupees to purchase the same one U.S. dollar. That is, the dollar has become more expensive in Indian rupee terms. The rupee, in turn, has depreciated.
On the other hand, the exchange rate is said to appreciate when the rate falls. It means fewer rupees are needed to buy one dollar.
Both appreciation and depreciation of a currency have their own sets of positives and negatives for the economy.
How The Exchange Rate Works Through The Economy?
For any economy involved in international trade, exchange rates are highly significant. It directly determines at what price a given country can purchase/sell goods and services from/to other countries.
Take crude oil. The price India pays for crude imports will not only depend on its actual price, but also how much it costs to purchase dollars in order to pay for the oil. So if the rupee exchange rate is depreciating, India has to shell out more rupees for the purchase. In other words, India’s crude oil imports have become dearer.
The opposite applies when India exports. A depreciating currency improves Indian exports’ competitiveness as our goods become cheaper in the international market and exporters get more bang for the buck. Thus, exchange rates influence the value of our exports and imports.
There’s another important repercussion of exchange rate movement: on inflation.
A depreciating domestic currency raises the price of imported goods. If the economy is highly dependent on imports for direct consumption or intermediate inputs for production, this increase gets ‘passed through’ to domestic prices. And that shows up in higher domestic inflation. That’s why central banks with an inflation targeting mandate often monitor the movements in exchange rates.
What Factors Influence A Country’s Exchange Rate?
If a country imports more than it exports and this ‘deficit’ widens, it would lead to an increased demand for dollars to import the goods and services (as dollar is most popularly used in trade), putting pressure on the domestic currency to depreciate.
Domestic macroeconomic conditions and interest rate differential:
If the economy is growing at a steady pace and inflation is stable, foreign investors are likely to invest in domestic assets (through, say foreign direct investment (FDI) or portfolio investment (FPI) seeking higher returns. An interest rate differential between two countries, where the domestic interest rates are higher, would also lead to higher capital inflows. An increase in capital inflows would increase demand for the domestic currency and make it appreciate.
Factors affecting the reference currency:
Remember exchange rate is a two-way relationship. Hence, factors affecting the reference currency (say the U.S. dollar) can also affect any country’s exchange rate. The pandemic drastically increased demand for U.S. dollars, as it is considered a ‘safe’ asset to hold in times of uncertainty. As the U.S. dollar appreciates, the domestic currency consequentially depreciates.
Market and regulatory factors:
Market speculation and regular trading in derivative assets of the currency can cause short-term movements in the exchange rate. Central bank interventions also play a role. In India, the RBI may buy or sell dollars to curb exchange rate volatility, which influences supply of and demand for the domestic currency.
Real vs Nominal — What Is The Difference?
So far, our discussion refers to the nominal exchange rate — which simply tells us how much it costs to purchase a foreign currency. But price levels also vary between countries. So to know what exactly one can buy at a given exchange rate, economists have devised a measure called the real exchange rate (RER).
The Big Mac Index first published in The Economist is a clever, though rather simplistic, tool that represents this. It shows what a comparable McDonald’s burger costs in one country vis-à-vis the other. Let’s say, a Big Mac costs Rs 190 in India and $5.7 in the U.S. Then the implied exchange rate is simply (190÷5.7) or Rs 33.3/$. This is just for one representative good (the Big Mac). If you combine more goods and services to understand what that basket costs in a country vis-à-vis the other, you get the RER.
A comparison of this with the nominal exchange rate gives a sense of whether the currency is over- or under-valued, and hence, in what direction it is likely to move. In practice, though, many market forces combine to determine currency movement.