Exchange Rates Part (II) 15 - Revision Notes

Currency Convertibility
Helps in increasing the trade competitiveness of a nation.

Types of convertibility :
Full convertibility Partial convertibility
All the transactions Limit on how

will not happen much foreign
on the official currency can
exchange rates be converted.
On the basis of ease of exchange of foreign currency:
Current Account Capital Account

Convertibility Convertibility:
Imposed by the IMF after the 1991 BoP crisis. India has a partial capital account
All the exchange at the market exchange rate convertibility for most of the transactions
Objective To make the Indian economy more
and more open
Why does India have partial Capital Account Convertibility ?
Risk of capital flight To have a balanced exchange rate

To check inflation in the domestic economy Issue with Current Account Deficit (CAD)
1996 recommendation of S.S Tarapore Committee on
Capital Account Convertibility :
To keep the non To keep the fiscal deficit

performing asset in ( to be kept below 3.5%
check less than 5% of GDP) and the current
of the GDP. account deficit in check.
To keep inflation in check

Healthy forex between 3-5% whereas
the RBI has flexible
monitoring of 2-6%.
Hard and Soft Currency
Hard Currency Soft Currency
Globally accepted for Do not dominate global
trading purposes trade
Dominates global trade Do not have a free
Has a free exchange rate. exchange rate.
Example: US dollar, yen , Example : Indian rupee.
British pound, yuan.
Hot currency:
A hard currency which is exiting the economy too quickly.
Exchange Rates :
The amount of domestic currency required to get a single unit of foreign currency.
Tells the value of foreign currency in comparison to a country's domestic currency.
Foreign currency's demand and supply to determine its price (value).
Types of Exchange Rates (ER):
Flexible / Pegged Free/Floating/Flexible Managed Free/ Floating

Exchange Rate Exchange Rate and flexible Exchange Rate
Appreciation of Currency :
Purchasing power of the currency has increased against the
value of foreign currency.
Case I Case II
App of Domestic App of Foreign
Eg- 80 ₹/$ Eg- 80 ₹/$
70 ₹/$ 90 ₹/$
In case 1: To get $1, we would have to pay 80 rupees. Now, once there is appreciation of the
Indian rupee, we now have to pay 70 rupees to get $1.
In case 2: Earlier to get $1, we would have to pay 80 rupees. Now, once there is depreciation of
the Indian rupee and appreciation of foreign currency, we now have to pay 90 rupees to get $1.
Depreciation of Currency:
Purchasing power of the currency has declined.
Depreciation Supply of currency in the market increases while its demand falls.
Case 1 Case 2
D1 D
D(I) S E D1 S
80 ₹/$ 70 ₹/$
P 70 ₹/$ P 60 ₹/$
Q Q
When there is a shift from D to D1, there is depreciation Decrease in demand (import), supply (export) remaining
of the Indian rupee because there is a constant rise in constant Depreciation of foreign currency and
imports in comparison to exports. appreciation of Indian rupee.
Case 3 Case 4
D S1 D S1
S2 S
70 ₹/$ 80 ₹/$
P P 70 ₹/$
60 ₹/$
Q Q
Rupee has appreciated and the dollar has Supply has decreased but demand is
depreciated Increase in supply in constant Appreciation of foreign
comparison to demand. currency and depreciation of the Indian rupee.
Effects of Appreciation and Depreciation of rupee:
If 70 ₹/$ to 60 ₹/$ If 70 ₹/$ to 80 ₹/$
* Imports will Become * Imports Costlier

cheaper
* Exports will rise
* Exports will Reduce
Revaluation of Currency:
Domestic currency over depreciated
RBI provides US dollars in the market cheaper than the market price
D1
D (I) S (E) RBI Selling cheap $ in
S1 Market from Forex
80 ₹/$
P 70 ₹/$
R Q
Devaluation of Currency:
Over appreciation of rupee RBI will purchase the cheap dollar at a
price higher than market price.
D(I) S (E) RBI will purchase

$ - on higher prices
than MP
70 ₹/$
P 50 ₹/$
Q
Internationalisation of Rupee:
* INR is accepted for different international transactions by a majority of countries.
* World trade is now dominated by INR.
What needs to be done for Internationalisation of Rupee ?

Shift from managed to free/floating exchange rate
Reduced level of CAD
Higher exports
Reduce the import dependency by reducing and replacing (substituting) imports.
De-dollarisation :
* Reducing dollar dominance in world trade.

* Can be done by internationalisation of rupee and establishing strong diplomatic relations.

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Currency Convertibility

Helps in increasing the trade competitiveness of a nation.

Full convertibility Partial convertibility

All the transactions Limit on how

Current Account Capital Account

Why does India have partial Capital Account Convertibility ?

Risk of capital flight To have a balanced exchange rate

To keep the non To keep the fiscal deficit

To keep inflation in check

Types of Exchange Rates (ER):

Flexible / Pegged Free/Floating/Flexible Managed Free/ Floating

If 70 ₹/$ to 60 ₹/$ If 70 ₹/$ to 80 ₹/$

* Imports will Become * Imports Costlier

D(I) S (E) RBI will purchase

What needs to be done for Internationalisation of Rupee ?

* Reducing dollar dominance in world trade.

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