What is the foreign exchange rate?
The foreign exchange rate is the price of one currency in terms of another. Example: $1 = ₹80. The market where currencies are bought and sold is the foreign exchange market.
- Depreciation: the rupee loses value in the market (₹80 → ₹85 per $).
- Appreciation: the rupee gains value in the market (₹80 → ₹75 per $).
Fixed, flexible and managed floating systems
1. Fixed exchange rate
The government or central bank fixes the rate. In the old gold standard, each currency was tied to gold. Later, many currencies were tied to the US dollar. The central bank buys or sells foreign currency to hold the rate. A deliberate government rise in the price of foreign currency is devaluation; a fall is revaluation.
2. Flexible (floating) exchange rate
The rate is set by demand and supply in the market, with no government action. Changes are called depreciation and appreciation.
3. Managed floating
A mix. The market sets the rate, but the central bank buys or sells foreign currency to stop sharp swings. India follows this since the 1990s. It is also called a dirty float.
Try it at home
Look up today's ₹ per $ rate in a newspaper for five days. Did the rupee appreciate or depreciate?
How the free market sets the rate
Demand for foreign exchange (why we need dollars)
- To import goods and services.
- To travel, study or get treatment abroad.
- To invest or buy assets abroad.
- To send gifts or repay foreign loans.
The demand curve slopes down: when the dollar gets dearer, imports cost more in rupees, so fewer dollars are demanded.
Supply of foreign exchange (where dollars come from)
- Our exports of goods and services.
- Foreign tourists spending here.
- Foreign investment (FDI, FPI) into India.
- Remittances from Indians working abroad.
The supply curve slopes up: when the dollar gets dearer, our goods look cheaper abroad, exports rise, and more dollars come in.
Equilibrium
The rate where demand = supply of dollars is the equilibrium rate. If demand rises, the rate rises (rupee depreciates). If supply rises, the rate falls (rupee appreciates).
Merits and demerits
| Fixed rate | Flexible rate | |
|---|---|---|
| Merits | Stable and certain; good for trade and long contracts; stops speculation | No need to hold big reserves; BoP corrects itself; free movement of capital |
| Demerits | Needs large reserves; can be over- or under-valued; BoP problems build up | Uncertain; risky for traders; speculation can cause wild swings |
Managed floating tries to keep the good parts of both: market flexibility with some stability.
Key formulas and definitions
- Exchange rate = rupees needed to buy one unit of foreign currency (₹ per $)
- Rate ↑ (₹80 → ₹85) = rupee depreciation; Rate ↓ = rupee appreciation
- Fixed system: govt raises rate = devaluation; lowers = revaluation
- Equilibrium rate: demand for foreign exchange = supply of foreign exchange
- % depreciation = (new rate − old rate) ÷ old rate × 100
Worked examples
1. $1 = ₹80. How many rupees are needed for $250?
250 × 80 = ₹20,000.
2. The rate moves from ₹80 to ₹84 per $ in the market. Has the rupee appreciated or depreciated? By what %?
More rupees per dollar, so the rupee depreciated. (84 − 80) ÷ 80 × 100 = 5%.
3. Demand for $: Q = 200 − 2R; supply of $: Q = 2R − 120. Find the equilibrium rate.
200 − 2R = 2R − 120 → 4R = 320 → R = ₹80; Q = 40 million dollars.
4. In the same market demand rises to Q = 220 − 2R. Find the new rate.
220 − 2R = 2R − 120 → R = ₹85. The rupee depreciates.
5. Under a fixed rate of ₹75 in the same (original) market, find the dollar shortage the RBI must fill.
Demand = 200 − 150 = 50; supply = 150 − 120 = 30. Shortage = 20 million dollars, sold from reserves.
6. An Indian shirt sells for ₹1,600. What does it cost in dollars at ₹80 and at ₹100 per $?
At ₹80: $20. At ₹100: $16. A weaker rupee makes Indian goods cheaper abroad, helping exports.
Common mistakes
- Thinking a rise in ₹ per $ means the rupee got stronger. It means the rupee got weaker (depreciated).
- Using 'devaluation' for a market fall. Devaluation is a government act under a fixed rate; the market change is depreciation.
- Putting exports on the demand side of foreign exchange. Exports bring dollars in: supply side.
- Saying India has a fully fixed or fully free rate. India follows managed floating.