Exchange Rate: Meaning, Types & Related Concepts

Exchange Rate

Exchange Rate is a pivotal element of the global economic system, affecting trade, investment, and
economic policy. Understanding the various exchange rate systems, the mechanisms behind currency
valuation, and the factors influencing exchange rates is crucial to navigating the complexities of
international finance. This article aims to study in detail the concept of Exchange Rate, its meaning,
types, and other related concepts such as Nominal Effective Exchange Rate (NEER), Real Effective
Exchange Rate (REER), Devaluation & Revaluation, etc.

• What is Exchange Rate?

• Types of Exchange Rate System

o Fixed Exchange Rate System

▪ Pegging

o Flexible Exchange Rate System

▪ Fixed Exchange Rate System Vs Flexible Exchange Rate System

o Managed Floating Rate System

• Devaluation and Revaluation

o What is Devaluation?

o What is Revaluation?

o Differences between Devaluation and Depreciation

• Currency Manipulation
 • Currency Manipulators

• Types of Exchange Rate Markets

o Spot Market

o Forward Market

• Factors Affecting Exchange Rates

• Nominal Effective Exchange Rate (NEER)

• Real Effective Exchange Rate (REER)

• Forex Reserve of India

o Foreign Currency Assets (FCAs)

o Gold

o Special Drawing Rights (SDRs)

o Reserve Tranche

• Purchasing Power Parity (PPP)

• Nominal GDP Vs Real GDP Vs GDP at PPP

o Nominal GDP

o Real GDP

o GDP at PPP

• Conclusion

What is Exchange Rate?

• Exchange Rate, or the rate of exchange, is the price of the currency of a nation in terms of
another currency i.e. the price at which one currency can be traded for another.

• The rate of exchange of a currency w.r.t. another currency reflects the relative demand of the
two currencies.

• For example, if the US Dollar is stronger than the Indian Rupee, it implies that value of the US
Dollar is higher w.r.t. the Indian Rupee).

o This, in turn, shows that the demand for US Dollars (by those holding Indian Rupees)
is more than the demand for Indian Rupees (by those holding US Dollars).

• The relative demands of the two currencies depend on the relative demand for the goods &
services of the two countries.

Types of Exchange Rate System

The major types of exchange rate system are as follows:

• Fixed Exchange Rate System or Pegged Exchange Rate System.

• Flexible Exchange Rate System or Floating Exchange Rate System.

 • Managed Floating Rate System.

Fixed Exchange Rate System

• It is the one wherein the rate of exchange for a currency is fixed by the government.

• Under this system, a country fixes the value of its currency in terms of some ‘External
Standard’, which can be precious metals such as gold or silver, or currency of some other
country or some internationally agreed unit of account.

• The main purpose of adopting this system is to ensure stability in capital movements and
foreign trade.

• To maintain stability, the government buys foreign currency when the exchange rate weakens
and sells foreign currency when it strengthens.

o In order to be able to do this, the government maintains large reserves of foreign

currencies.

Pegging

When the value of the domestic currency is tied to the value of another currency or in terms of gold,
it is known as ‘Pegging.’

Flexible Exchange Rate System

• It is also known as a ‘Floating Exchange Rate’.

• In this system, the rate of exchange is determined by forces of demand and supply of the
currencies in the foreign exchange market i.e. by the market through interactions of firms,
banks, and other institutions involved in buying and selling of currencies.

• The value of the currency is allowed to fluctuate freely according to changes in the demand
and supply of foreign exchange.

• In this system, there is no intervention of the government in the foreign exchange market.

Fixed Exchange Rate System Vs Flexible Exchange Rate System

Basis of Differences Fixed Exchange Rate Flexible Exchange Rate

Determination of It is officially fixed in terms of gold or any It is determined by forces of demand and
Exchange Rate other currency by the government. supply.

There is complete government control as There is no government intervention and it

Government Control only the government has the power to fluctuates freely according to market
change it. conditions.

The rate of exchange generally remains

Stability stable, and only a small variation is The rate of exchange keeps on changing.
possible.

Currency is devalued and if any changes Currency appreciates and depreciates in

Impact on Currency
take place in the currency, it is revalued. this system.
 Basis of Differences Fixed Exchange Rate Flexible Exchange Rate

Involvement of Government bank determines the rate of No such involvement of government

Government Bank exchange. banks.

Need for Maintaining

Foreign reserves need to be maintained. No need to maintain foreign reserves.
Foreign Reserve

Impact on BOP This can cause a deficit in BOP that A deficit or surplus in BOP is automatically
(Balance of Payment) cannot be adjusted. corrected.

Managed Floating Rate System

• It is a system having characteristics which is hybrid of both fixed as well as flexible exchange
rate systems.

• In this system, rate of exchange is determined by market forces, but, time to time, the
Central Bank intervenes in the foreign exchange market to keep the fluctuations within
certain limits.

o It is also known as ‘Dirty Floating’.

Devaluation and Revaluation

What is Devaluation?

Devaluation refers to a reduction in the value of domestic currency by the government.

What is Revaluation?

• Revaluation refers to an increase in the value of domestic currency by the government.

• Revaluation refers to a situation when the value of a currency w.r.t a foreign currency
increases in a fixed exchange rate.

Note: Altering the face value of a currency, without changing its foreign exchange rate, is called
redenomination.

Differences between Devaluation and Depreciation

Dimensions Devaluation Depreciation

Devaluation refers to a reduction in the price of Depreciation refers to a fall in the market price
Meaning domestic currency in terms of all foreign of a country’s currency in terms of a foreign
currencies. currency.

It takes place due to market forces of demand

Occurrence It takes place due to the Government.
and supply.

System It takes place in a fixed exchange rate system. It takes place in a flexible exchange rate system.

Currency Manipulation

• This is a “unfair currency practices” wherein a country devalues its domestic currency’s value
against the dollar deliberately.
 • The practice would mean that the country in question is lowering the value of its currency
artificially in order to gain unfair advantages over others.

o Devaluation reduces the cost of exports from that country and hence trade deficits.

Currency Manipulators

• The US Department of Treasury publishes a semi-annual report which monitors

developments in the international economies and foreign exchange rates therein.

• It reviews the currency practices of the US’ 20 biggest trading partners.

• An economy meeting two of the following three criteria (as mentioned in the Trade
Facilitation and Trade Enforcement Act of 2015) is kept on the Watch List:

o A bilateral trade surplus of at least USD 20 billion with the USA over a a period of 12
months.

o A material current account surplus of worth at least 2% of Gross Domestic Product

(GDP) over a period of 12 months.

o Purchases of foreign currency worth at least 2% of the country’s GDP in at least six
out of 12 months period.

• Countries that meet all three of the criteria are labelled as currency manipulators by the
Treasury.

Types of Exchange Rate Markets

Spot Market

• It refers to a market wherein the purchase and sale of foreign currency are settled within 2
days of the deal.

• The rate at which the foreign currency is bought and sold is called the spot exchange rate.

Forward Market

• It refers to that market, which deals in the sale and purchase of foreign currency at some
future date at a pre-settled rate of exchange, called forward exchange rate.

• When sellers and buyers enter an agreement to sell and buy a foreign currency after 90 days
of the deal, it is called a forward transaction.

Factors Affecting Exchange Rates

• Intervention of the Reserve Bank of India: During high volatility in the rate of exchange, the
RBI intervenes to keep that in control. e.g. it sells US Dollars when the Indian Rupee
depreciates too much, or purchases US Dollars when the Indian Rupee appreciates beyond a
certain level.

• Inflation Rate: The increase in inflation rate can lead to an increase in the demand for
foreign currency, thus negatively impacting the rate of exchange of the domestic currency.
For example, an increased price of petroleum oil can increase the demand for foreign
currency, thus leading to the depreciation of Indian Rupee.
 • Interest Rate: Interest rates on corporate securities, or government securities and bonds,
impact the inflow and outflow of foreign currency. When interest rates on government bonds
are higher compared to those in other countries, it can attract foreign currency inflows, while
lower interest rates may lead to outflows. This, in turn, impacts the rate of exchange of the
Indian rupee.

• Exports and Imports: Exports earn foreign currency whereas imports require payments in
foreign currency. Therefore, if exports rise, the national currency tends to appreciate,
whereas an increase in imports usually results in the depreciation of the national currency.

• Other Factors: Indian foreign exchange market is also affected by other factors such as inflow
in the capital account such as FDI, receipts in the accounts of exports in invisible in the
current account,, external commercial borrowings, foreign institutional investments, NRI
deposits, tourism activities etc.

Nominal Effective Exchange Rate (NEER)

• The Nominal Effective Exchange Rate (NEER) refers to the weighted average of bilateral
nominal exchange rate of the domestic currency in terms of foreign currencies.

• In other words, It is the rate of exchange of one currency relative to a basket of currencies,
with weights based on trade volume with each country (not adjusted for inflation).

NEER = Domestic currency exchange rate in terms of SDR / Foreign currency exchange rate in terms
of SDR.

Real Effective Exchange Rate (REER)

• The Real Effective Exchange Rate (REER) is the weighted average of a country’s domestic
currency against a basket of major currencies, adjusted for inflation.

• The weights are determined according to the relative trade balance of a country’s currency
with each country included in the index.

REER = NEER × (Domestic Price Index / Foreign Price Index)

Forex Reserve of India

• Foreign Exchange of a country reserves refers to the foreign currencies held by a country’s
central bank.

• It is also called foreign reserves or foreign currency reserves.

• One of the most important reasons for holding reserves is to manage the currency’s value.

• Foreign Exchange reserves consist of the following:

o Foreign Currency Assets

o Gold

o Special Drawing Rights (SDR) holdings of the government

o Reserve Tranche

Foreign Currency Assets (FCAs)

 • The currencies of various countries held in foreign exchange reserves are called foreign
currency assets. For example, reserves held in US Dollars, Euro, Japanese Yen, etc.

• Apart from currencies, it includes foreign bank deposits, foreign treasury bills and short-term
and long-term foreign government securities.

• The deposit agreements with IMF trust is also a part of FCAs and are readily available to
meet a BOP financing need.

Gold

The RBI uses its gold stock as a back up to issue currency and meet the unexpected Balance of
Payment problems.

Special Drawing Rights (SDRs)

• The Special Drawing Right (SDR) is an international reserve asset, created by the IMF, to
supplement official reserves of its member countries, and help them meet Balance of
Payment problem.

• It was created by the IMF in 1969.

o The member countries contribute to this account to avail of this benefit.

• The contribution is in proportion of their IMF quota (membership fee).

• Special Drawing Rights can be exchanged for freely usable currencies.

• The value of the SDR is based on a basket of five major currencies – the US dollar, the Euro,
the Japanese yen, the British Pound Sterling, and the Chinese renminbi (RMB).

• The SDR is neither a claim on the IMF nor a currency. It is, rather, a potential claim on the
freely usable currencies of IMF members.

• Holders of SDRs can obtain freely usable currencies in exchange for their SDRs in two ways:

o Through the arrangement of voluntary exchanges between members.

o IMF designates members with strong external positions to purchase SDRs from those
with weaker external positions.

Reserve Tranche

• It is the portion of the required quota of currency that each IMF member country must
contribute to the IMF, but can designate for its own use.

• The reserve tranche portion of the quota can be accessed by the member at any time,
whereas the rest of the member’s quota is typically inaccessible.

• If any money was lent over and above the quota to the IMF’s General Resource Account, it
becomes part of the Reserve Tranche.

Purchasing Power Parity (PPP)

• Purchasing Power Parity (PPP), as an economic concept, compares currencies of different

countries through a market “basket of goods” approach.
 • According to this concept, two currencies are in equilibrium or at parity when a market
basket of goods, adjusted for the rate of exchange, costs the same in both countries.

• Using PPPs is the alternative to using market exchange rates.

• The actual purchasing power of a currency is the amount of that currency required to
purchase a specific unit of a good or a basket of common goods and services.

• PPP (Purchasing Power Parity) is determined in each country based on its relative cost of
living and inflation rates.

• Purchasing power parity ultimately means equalising the purchasing power of two currencies
by accounting for differences in the cost of living and inflation rates.

• For example, a smartphone that costs around ₹3,000 in India would cost around $40 in the
USA if the rate of exchange is considered as ₹75 for $1.

• The purchasing power parity is one of the most important macroeconomic metrics that are
used by economists in determining the economic productivity and living standards of a
country.

• PPP is based on the law of one price, which states that identical goods will have the same
price.

The purchasing power parity formula can be expressed as follows:

S = P1/P2

Where,
S = Rate of Exchange of currency 1 in terms of currency 2
P1 = Cost of a good in currency 1
P2 = Cost of the same good in currency 2

Nominal GDP Vs Real GDP Vs GDP at PPP

• In contemporary macroeconomics, GDP refers to the total monetary value of the goods and
services produced within one country.

• It is one of the primary indicators used to evaluate a country’s economy and can be
calculated in market exchange terms (Nominal) and in purchasing power parity (PPP) terms.

Nominal GDP

• Nominal GDP calculates the monetary value in current, absolute terms.

Real GDP

• Real GDP takes the nominal GDP and adjusts it for inflation.

GDP at PPP

• GDP at PPP takes into consideration the relative costs of local goods and services produced in
a country valued at prices of the United States.

• It factors in rate of exchange and the inflation rates of each country.

• GDP at PPP reflects the purchasing power of a citizen in one country to a citizen of another.
 o For example, a pair of shoes may cost less in one country than in another, so
purchasing power parity is needed for fairness in the calculation.

• One way to think of what GDP with PPP represents is to imagine the total collective
purchasing power of India if it were used to make the same purchases in U.S. markets.

• This only works after all Rupees are exchanged for dollars. Otherwise, the comparison does
not make sense.

o Thus, the net effect is to describe how many dollars it takes to buy $1 worth of goods
in India as opposed to in the U.S.

Conclusion

Exchange Rate plays an important role in the global economy, influencing everything from
international trade and investment to the daily cost of living for individuals around the world. This
rate reflects the relative demand and supply of different currencies and is influenced by various
economic factors, including inflation, interest rates, and trade balances. Understanding the types of
systems of rate of exchange, the mechanisms behind currency valuation, and its impact on a
country’s economy is crucial for grasping the complexities of international finance.