Foreign exchange rate

Also called: Exchange rate, Forex rate, Nominal exchange rate · Topic: Balance of Payments and Exchange Rates · NCERT: Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

The foreign exchange rate (also called the exchange rate, forex rate or nominal exchange rate) is the price of one currency in terms of another currency. For example, the number of rupees needed to buy one US dollar.

It matters because it sets the rupee price of everything India buys from abroad, like oil and machines. It also sets the dollar price of everything India sells abroad, and the value of foreign loans and investment.

• Direct quote = rupees per 1 unit of foreign currency (₹50 per $1)
• Indirect quote = 1 ÷ direct quote (₹50/$ = $0.02 per ₹1)

Explanation

How the rate is set: demand and supply of foreign exchange

• Foreign exchange means foreign currencies, plus claims payable in them, such as dollar bank deposits and dollar bills.
• Foreign exchange market means the market where one currency is traded for another.
• It has no single building. It is world-wide. Mumbai, Singapore, London and New York are in constant contact by phone and computer.
• Trading hours in different cities overlap, so the market runs almost round the clock.

• Who trades: commercial banks (they do most of the trading), forex brokers (they bring buyers and sellers together for a fee), other authorised dealers, and central banks such as the RBI.

• Demand for dollars comes from imports, gifts and transfers sent abroad, and Indians buying foreign assets such as shares, bonds and 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 import less, so they demand fewer dollars.

• Supply of dollars comes from exports, transfers and remittances from abroad (money sent home by Indians working abroad), and foreigners buying Indian assets (FDI, FPI).

• 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.

• Caveat on elasticity (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 export volume hardly rises. Total dollar earnings may then fall.
• Marshall–Lerner condition: depreciation improves the trade balance only if the export and import demand elasticities add up to more than 1.
• J-curve: in the short run the trade balance often gets worse first, and improves only later.

Depreciation and appreciation, with a worked example

• Flexible (floating) exchange rate: the rate settles where the demand for dollars equals the supply of dollars, with no central bank intervention.
• Worked example, where demand shifts:
• More Indians travel abroad, so they need more dollars.
• The demand curve for dollars shifts right.
• At the old rate, more people want dollars than are on offer, so the dollar's price rises.

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

• Depreciation means the rupee loses value, so more rupees are needed per dollar (₹50 → ₹70).

• Appreciation is the reverse. Fewer rupees are needed per dollar (₹70 → ₹50).
• Percentage trap, using the same numbers:
• The dollar gains (70 − 50) ÷ 50 = 40% in rupee terms.
• The rupee falls from $0.0200 to $0.0143, a fall of about 28.6%.

• The two percentages are not equal, because each is worked out on a different base.

• Trap: under a direct quote, a higher number means a weaker rupee.

What moves the rate in the short run (Class 12)

Trade flows matter over the long run. In the short run, capital flows, expectations and interest rates move the rate.

• Speculation. Money is also an asset. People hold a currency because they hope its value will rise.
• The pound is at ₹80, and investors expect ₹85 by month-end.
• They buy 1,000 pounds for ₹80,000 and sell them for ₹85,000, a profit of ₹5,000.

• If many investors act on the same belief, demand for pounds rises today. The pound rises today, so the expectation fulfils itself.

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

• Bonds pay 8% in country A and 10% in country B.
• Investors sell A's currency to buy B's bonds.
• A's currency depreciates and B's currency appreciates.

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

• Income:

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

Beyond NCERT: interest rate parity, carry trade and NDF

• Interest rate parity (IRP): the interest gap between two countries equals the expected change in their exchange rate. So no arbitrage is left (arbitrage means a sure, risk-free profit from price gaps).
• Covered IRP: the forward premium ≈ the interest differential. The investor fixes the future rate in advance through a forward contract.
• Formula: F = S × (1 + i_home) / (1 + i_foreign). F is the forward rate, S is the spot (today's) rate, and i is the interest rate.
• Example: S = ₹83/$, India 7%, US 4%. F = 83 × 1.07 / 1.04 = ₹85.39. The shortcut (a 3% premium) gives about ₹85.49.

• Uncovered IRP: expected depreciation ≈ the interest differential. There is no forward cover, so the investor bears the currency risk. If India pays 3% more than the US, the rupee is expected to fall about 3% a year against the dollar.

• Carry trade: borrow in a low-interest currency such as the yen, then invest in higher-yield assets elsewhere.

• The Bank of Japan raised rates on 31 July 2024, and weak US jobs data came on 2 August 2024 [8].
• The yen rose sharply, and investors rushed to repay yen loans. This was a large unwinding of carry trades [8].

• Japan's Nikkei fell 12% in one day, its biggest one-day move since 1987 [8]. By mid-August 2024 the yen was steady near 140 per dollar [8].

• Non-deliverable forward (NDF): an offshore forward contract in a non-convertible currency such as the rupee. At maturity it is settled in dollars on the rate difference. No rupees change hands.

• Example: the contract is $1 million at ₹84/$, and the rate on maturity is ₹85/$.
• The dollar buyer gains (85 − 84) × 10,00,000 = ₹10 lakh. This is paid as ₹10,00,000 ÷ 85 ≈ $11,765.

In India

• From peg to market rate:
• Bretton Woods (1944 to the early 1970s): the rupee was pegged (fixed) to the dollar. The rate changed only through official devaluation.
• 1991 BoP crisis: forex reserves ran very low, and the rupee was devalued as part of the reforms [NCERT, class 11].
• March 1992: LERMS (Liberalised Exchange Rate Management System) began. It had a dual exchange rate, meaning one official rate and one market rate [9].

• 1 March 1993: a unified, market-determined exchange rate replaced it. After this the RBI no longer had to sell foreign exchange at a fixed rate [9].

• Managed float today: the market sets the rate, but the RBI steps in.

• The RBI says it intervenes only to curb excessive volatility (sharp swings in the rate) [4].
• Its tools are spot buying and selling, forwards and swaps, including "sell-buy" swaps (selling dollars now and agreeing to buy them back later) [4].

• Why swings matter: they raise costs for trade and investment and make monetary policy harder. An example is the taper tantrum after 22 May 2013, when the rupee swung sharply on fears that the US Fed would slow its bond buying [5].

• IMF labels:

• De jure (what the law says): floating.
• De facto (what the IMF sees in practice): crawl-like arrangement (2025 Article IV) [6].

• In the 2023 Article IV, IMF staff reclassified India's de facto regime for December 2022–October 2023. India disagreed. It said the stable rupee reflected a stronger external position, and that intervention only checked swings not justified by fundamentals [7].

• Size of the market:

• Average daily global OTC turnover in the rupee was $122 billion in April 2022, up from $114 billion in 2019 and $58 billion in 2016 [4]. OTC (over-the-counter) means deals made directly between two parties, not on an exchange.

• Over 60% of this was offshore in 2022 (deals made outside India), mostly NDFs [4].

• Bringing trade back to India: from 1 June 2020, banks in India with IFSC Banking Units (IBUs) could trade in the rupee NDF market [2][3]. An IFSC is a special zone for international finance, such as GIFT City in Gujarat.

Don't confuse with

• Depreciation vs Devaluation: depreciation is a fall in the rupee caused by the market under a float. Devaluation is an official cut in a fixed or pegged rate, as under Bretton Woods or in 1991.
• Direct quote vs Indirect quote: a direct quote gives rupees per $ (₹50), so a rise means a weaker rupee. An indirect quote gives $ per rupee ($0.02), so a rise means a stronger rupee.
• Nominal vs Real exchange rate: the nominal rate is the plain price of one currency in another. The real exchange rate also adjusts for price levels in the two countries, so it shows whether Indian goods are really cheaper or dearer abroad.
• Flexible rate vs Managed float: a flexible rate is set only by demand and supply, with no central bank action. A managed float is market-set, but the RBI steps in to smooth sharp swings.

Prelims Hooks

• ₹50 = $1 is a direct quote. A move to ₹70 = $1 is rupee depreciation, not appreciation.
• ₹50 → ₹70 per $: the dollar gains 40%, but the rupee loses only about 28.6%.
• LERMS (dual rate): March 1992 → unified market-determined rate: 1 March 1993 [9].
• A rise in home interest rates → home currency appreciates, assuming free capital movement. Faster growth in aggregate demand than the world → currency usually depreciates.
• Covered IRP: forward premium ≈ interest differential. Uncovered IRP: expected depreciation ≈ interest differential.
• IMF label for India: de jure floating, de facto crawl-like arrangement [6]. NDF: offshore, settled in dollars, no rupee delivery. IBUs were allowed in from 1 June 2020 [2].

Mains Points

• Managed float as a middle path:
• A pure float lets events like carry-trade unwinds and taper tantrums swing the rupee wildly.
• A peg can lead to a 1991-style crisis when reserves run out.

• The RBI's action against "excessive volatility" tries to balance the two [4][5]. But the IMF's 2023 reclassification shows the risk: too much smoothing can look like a hidden peg to outsiders [7].

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

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

• So when capital moves freely, the RBI cannot fully control both the interest rate and the exchange rate at the same time.

• A weaker rupee does not automatically fix a trade deficit:

• It helps only if elasticities are large enough (Marshall–Lerner), and the J-curve can make the deficit worse at first.
• India imports a lot of oil, and oil demand hardly reacts to price. This limits "depreciate to export more" strategies.
• Separately, most rupee trading is offshore, so the rupee's price is largely discovered outside India [4]. Letting IBUs trade NDFs brings this trading back under Indian regulators, which links to GIFT City and rupee internationalisation [2][3].

Related concepts

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

Read more

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