Foreign Exchange Determination Systems
Basic Concepts Relating to Foreign Exchange
| Term |
Explanation |
| Foreign Exchange (Forex) |
The currency of another country that is used for international trade and investment. Example: USD, Euro, Yen. |
| Foreign Exchange Market (Forex Market) |
A global decentralized market where currencies are bought and sold. |
| Exchange Rate |
The price of one country’s currency in terms of another country’s currency. Example: 1 USD = 83 INR. |
| Appreciation |
When a currency's value increases relative to another currency. Example: INR strengthens from 85 to 83 per USD. |
| Depreciation |
When a currency's value decreases relative to another currency. Example: INR weakens from 80 to 83 per USD. |
| Spot Rate |
Current exchange rate for immediate delivery of currency. |
| Forward Rate |
Agreed exchange rate for future delivery (e.g., 3 or 6 months later). |
| Bid Rate |
Rate at which the forex dealer buys foreign currency. |
| Ask Rate (Offer Rate) |
Rate at which the dealer sells foreign currency. |
| Spread |
Difference between the bid and ask rate; dealer’s profit margin. |
Exchange Rate Determination
| Theory |
Explanation |
| Purchasing Power Parity (PPP) |
Exchange rate adjusts so that the same basket of goods costs the same in two countries. |
| Interest Rate Parity (IRP) |
Difference in interest rates between two countries equals the difference between forward and spot exchange rates. |
| Balance of Payments Theory |
Exchange rate is determined by demand and supply of foreign exchange from trade, investment, etc. |
| Monetary Approach |
Exchange rate changes reflect differences in money supply and demand in different countries. |
Types of Exchange Rate Regimes
An exchange rate regime is the way a country manages its currency in relation to other currencies.
Comparison Table
Summary
Factors Affecting Exchange Rates
Exchange rates are influenced by multiple economic, political, and market-related factors. Below is a summary of key factors:
| Factor |
Explanation |
| 1. Inflation Rate |
Countries with low inflation rates tend to have stronger (appreciating) currencies. Higher inflation leads to depreciation. |
| 2. Interest Rates |
Higher interest rates attract foreign capital, increasing demand for local currency and appreciation. |
| 3. Balance of Payments (BoP) |
A trade surplus (exports > imports) strengthens currency; a trade deficit weakens it. |
| 4. Government Debt (Fiscal Deficit) |
High national debt may lead to depreciation as investors fear inflation or default. |
| 5. Political Stability & Economic Performance |
Stable governments and strong economies attract foreign investment, boosting currency value. |
| 6. Foreign Exchange Reserves |
Higher reserves help central banks manage exchange rates effectively, adding stability. |
| 7. Speculation & Market Sentiment |
If investors expect a currency to rise, demand increases now, causing appreciation. |
| 8. Central Bank Intervention |
Central banks may buy/sell currency to influence exchange rates (e.g., RBI in India). |
| 9. Terms of Trade |
If export prices rise relative to import prices, currency value increases. |
| 10. Global Events |
Wars, pandemics, oil price shocks can create volatility and affect exchange rates. |
Brief History of the Indian Rupee (₹)
Ancient to Medieval Times
- The word "Rupee" is derived from the Sanskrit word Rupya, meaning silver coin.
- Sher Shah Suri (1540s) issued the first silver "Rupiya" coin (weight ~11.34 grams).
British Rule Era
| Period |
Key Developments |
| Pre-1835 |
Coins of different designs in different regions. |
| 1835 |
Uniform silver coin issued under the Coinage Act. |
| 1862 |
British India introduced coins with Queen Victoria’s image. |
| 1893 |
India adopted a Gold Exchange Standard (rupee linked to British Pound). |
Post-Independence (1947 onwards)
| Year |
Event |
| 1947 |
India gained independence; rupee pegged to British Pound. |
| 1957 |
Decimalization: 1 Rupee = 100 Paise. |
| 1966 |
First major devaluation due to economic crisis; rupee devalued from ₹4.76/USD to ₹7.50/USD. |
| 1971 |
US abandoned gold standard; India moved to a Pegged exchange rate system with USD. |
| 1991 |
Balance of Payments crisis; major rupee devaluation; from ₹17.90/USD to ₹25.95/USD. |
| 1993 |
India adopted Market-Determined Exchange Rate (Liberalization). |
| 2000s |
Rupee fluctuated due to global events (e.g., 2008 crisis, oil prices). |
| 2016 |
Introduction of New Currency Notes (₹500, ₹2000) during demonetization. |
| Present |
Managed Float System – RBI intervenes to stabilize rupee; currently around ₹83–85/USD (2025). |
Interesting Facts
- RBI issues currency notes, while Government of India mints coins.
- Indian rupee symbol ₹ was adopted in 2010 (designed by Udaya Kumar).
- Rupee is not fully convertible on capital account, only on current account (for trade).
Summary Table
