Flexible exchange rate

Also called: Market-determined exchange rate, Floating exchange rate · Topic: Balance of Payments and Exchange Rates · NCERT: Class 11, Ch 3 "Liberalisation, Privatisation and Globalisation: An Appraisal"; Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

A flexible exchange rate (also called a floating or market-determined exchange rate) is an exchange rate set only by the market, at the point where the demand for foreign exchange equals its supply, with no buying or selling by the central bank.

• It matters because the price of the rupee affects the cost of imports (such as oil), the earnings of exporters, foreign investment and inflation.
• India follows a managed float. The market sets the rate, but the RBI steps in to stop sharp swings.

Explanation

How the rate is set

• Foreign exchange market: the market where one currency is traded for another, such as rupees for dollars. It has no single building. Centres such as Mumbai, Singapore, London and New York stay in constant contact, and the market runs almost round the clock.
• Exchange rate: the price of one currency in terms of another.
• Direct quote: rupees needed for one unit of foreign currency, for example ₹50 per $1.

• Under a direct quote, a higher number means a weaker rupee.

• Demand for dollars comes from imports, gifts and transfers sent abroad, and buying foreign assets (shares, bonds, property).

• The demand curve slopes down:

  • The rate rises from ₹50 to ₹60 per $.
  • A $100 import now costs ₹6,000 instead of ₹5,000.
  • Indians buy fewer imports, so they demand fewer dollars.

• Supply of dollars comes from exports, remittances (money sent home by Indians working abroad) and foreign purchases of Indian assets, meaning FDI (foreign direct investment) and FPI (foreign portfolio investment).

• The supply curve usually slopes up:

  • The rate rises from ₹50 to ₹60 per $.
  • A ₹600 Indian good now costs a foreigner $10 instead of $12.
  • Foreigners buy more, so more dollars usually come in.

• Equilibrium: the rate settles where the quantity of dollars demanded equals the quantity supplied. Under a pure float, the central bank does not step in to buy or sell.

Depreciation and appreciation: worked example

• Shift in demand:
• More Indians travel abroad, so they need more dollars.
• The demand curve for dollars shifts right.
• At the old rate, people want more dollars than are on offer, so the price of the dollar rises.

• The rate moves from ₹50 to ₹70 per $.

• Currency depreciation: the home currency loses value, so more rupees are needed per dollar (₹50 → ₹70).

• Currency appreciation: the home currency gains value, so fewer rupees are needed per dollar (₹70 → ₹50).
• The percentage trap:
• The dollar gains (70 − 50) / 50 = 40% in rupee terms.
• The rupee's value falls from $0.0200 to $0.0143, a fall of about 28.6%.
• The two numbers differ because each one is worked out from a different starting value.

What moves a floating rate in the short run

Trade flows matter over the long run. In the short run, the rate is moved mostly by capital flows, expectations and interest rates.

• Speculation: holding a currency in the hope of gaining when its value rises.
• Suppose the pound is at ₹80 and investors expect ₹85 by month-end. Buying 1,000 pounds for ₹80,000 and selling them for ₹85,000 gives a profit of ₹5,000.

• When many investors share this belief, they buy pounds today, so the pound rises today. The expectation fulfils itself.

• Interest rate differential (the gap between interest rates in two countries):

• Suppose bonds pay 8% in country A and 10% in country B.
• Investors sell A's currency and buy B's to earn the higher return.
• A's currency depreciates and B's appreciates.

• Rule: a rise in home interest rates tends to appreciate the home currency. This assumes capital can move freely. Capital controls weaken the effect.

• Income:

• Home income rises → imports rise → demand for dollars rises → the home currency depreciates.
• A country whose aggregate demand (total spending in the economy) grows faster than the world's usually sees its currency depreciate.

Does depreciation always help exports?

• Elasticity means how strongly buyers react to a change in price.
• If foreign demand for Indian exports is inelastic (it barely reacts to price), each export earns fewer dollars and sales hardly rise. Total dollar earnings may then fall.
• Marshall–Lerner condition: depreciation improves the trade balance only if the export and import demand elasticities together add up to more than 1.
• J-curve: after a depreciation, the trade balance often gets worse first and improves later.

In India

• Before 1991: under Bretton Woods (1944 to the early 1970s), currencies were pegged (fixed) to the dollar and changed only by official devaluation. The rupee was pegged too.
• 1991 BoP crisis: forex reserves ran very low, and the rupee was devalued as part of the reforms [NCERT, class 11].
• March 1992, LERMS: the Liberalised Exchange Rate Management System began. It used a dual exchange rate, meaning one official rate and one market rate. It was the first step towards a market-determined rate [6].
• 1 March 1993: LERMS gave way to a unified, single market-determined exchange rate, based on the demand for and supply of foreign exchange [6].

• After this, the RBI no longer had to sell foreign exchange at a fixed rate. All commercial deals moved to market rates [6].

• Managed float today:

• The RBI says it intervenes only to curb excessive volatility (sharp swings in the rate) [2].
• Its tools are spot buying and selling, forwards and swaps, including "sell-buy" swaps, meaning it sells dollars now and agrees to buy them back later [2].

• Why volatility matters: sharp swings raise costs for trade and investment and make monetary policy harder. One example is the taper tantrum after 22 May 2013. The rupee swung sharply on fears that the US Fed would slow its bond buying [3].

• IMF labels:

• De jure (what the law says): floating.
• De facto (what the IMF sees in practice): a crawl-like arrangement (2025 Article IV) [4].

• In the 2023 Article IV, IMF staff reclassified India's de facto regime for December 2022 to October 2023. India disagreed. It said the stable rupee reflected a stronger external position, and that intervention only checked swings not justified by fundamentals [5].

• Market size: average daily global over-the-counter (OTC) turnover involving the rupee was $122 billion (April 2022). OTC means deals made directly between two parties, not on an exchange. Over 60% of this was offshore, meaning outside India [2].

Don't confuse with

• Fixed (pegged) exchange rate: the government or central bank fixes the rate, and it changes only by an official decision, as under Bretton Woods. A flexible rate moves every day with demand and supply.
• Managed float: the market sets the rate, but the central bank steps in to smooth swings. This is India's actual system. A pure flexible rate has no intervention.
• Devaluation: an official cut in a fixed or pegged rate, as in India's 1991 crisis. Depreciation is a fall caused by the market under a float.
• Indirect quote: foreign currency per unit of home currency. ₹50/$ is the same as $0.02 per ₹1. Under a direct quote (₹ per $), a rise in the number means the rupee has weakened, not strengthened.

Prelims Hooks

• Flexible rate = the rate where demand for foreign exchange equals supply, with no central bank intervention.
• ₹50 → ₹70 per $ is rupee depreciation. The dollar gains 40%, but the rupee loses only about 28.6%.
• LERMS (dual rate): March 1992 → unified market-determined rate: 1 March 1993 [6].
• A rise in home interest rates → home currency appreciates, assuming free capital movement. Faster growth in aggregate demand than the world's usually leads to depreciation.
• India's regime: de jure floating, de facto crawl-like arrangement (IMF, 2025 Article IV) [4].
• The RBI intervenes only to curb excessive volatility. It does not target a fixed level [2].

Mains Points

• Managed float as a middle path:
• A pure float can let shocks swing the rupee sharply, as in the 2013 taper tantrum [3].
• A peg can end in a 1991-style crisis when reserves run out.

• RBI intervention against "excessive volatility" tries to balance the two [2]. The IMF's 2023 reclassification shows the risk: too much smoothing can look like a hidden peg to outsiders [5].

• Interest rates and exchange rates are linked (impossible trinity):

• A repo rate cut (the repo rate is the rate at which the RBI lends money to banks for a short time) can push capital out of India.
• The rupee weakens, and imported inflation rises, especially through oil.

• So with free capital movement, the RBI cannot fully control both the interest rate and the exchange rate at the same time.

• A floating rate does not automatically fix a trade deficit:

• Depreciation helps only if the elasticities are large enough (Marshall–Lerner), and in the short run the J-curve can make the deficit worse.
• India imports a lot of oil, and oil demand is inelastic. This limits a "depreciate to boost exports" strategy.

Related concepts

• Foreign exchange market
• Foreign exchange
• Foreign exchange rate
• Demand for foreign exchange
• Supply of foreign exchange
• Currency depreciation
• Currency appreciation
• Currency speculation
• Interest rate differential
• Interest rate parity

Read more

• The foreign exchange market and short-run exchange-rate determination