Exchange Rate

Notes

The exchange rate is the price of one currency in terms of another (for example, rupees per US dollar).

Exchange rate regimes

Fixed (pegged): the currency is tied to another currency or gold (the Bretton Woods system, 1944).
Floating: determined by market demand and supply.
Managed float (dirty float): market-determined, with central bank intervention. India follows a managed float.
Crawling peg, currency board.

India's history

1947-71: par value pegged to the pound sterling (then the dollar). 1975-92: managed against a basket of currencies. July 1991: devaluation. March 1992: LERMS (dual exchange rate). March 1993: unified, market-determined rate. 1994: current account convertibility.
Rupee internationalisation: since 2022 the RBI has allowed trade settlement in rupees through Special Rupee Vostro Accounts.

Measures of competitiveness

NEER (Nominal Effective Exchange Rate): a trade-weighted average of the rupee against several currencies.
REER (Real Effective Exchange Rate): NEER adjusted for inflation differences; a REER above the base of 100 means the rupee is overvalued (a loss of export competitiveness).

Determinants: inflation differentials (Purchasing Power Parity), interest rate differentials (interest rate parity), trade and current account balance, capital flows, speculation and central bank intervention, and the strength of the dollar (the Dollar Index, DXY).

Impact of a weaker rupee: exports become cheaper and imports costlier; imported inflation (oil); a bigger external debt burden; remittances are worth more in rupees. A stronger rupee has the opposite effects.

RBI's role: intervention by buying or selling dollars, forex swaps and forward market operations, to curb excess volatility, not to fix a level.

Impossible trinity (trilemma): a country cannot have a fixed exchange rate, free capital mobility and independent monetary policy at the same time. India opts for an independent monetary policy, a managed exchange rate and partial capital controls.

Key Points

Exchange rate = price of one currency in terms of another; India has a managed float.
1993: unified market-determined rate; 1994: current account convertibility.
NEER and REER measure competitiveness; REER above 100 means overvaluation.
Depreciation helps exports but raises import costs and external debt burden.
Impossible trinity limits policy choices.

MCQs

Q1. India follows which exchange rate system? (a) Fixed peg (b) Free float (c) Managed float (d) Currency board Ans: (c).

Q2. A REER above 100 indicates: (a) An undervalued currency (b) An overvalued currency (c) A fixed exchange rate (d) A trade surplus Ans: (b).

Q3. The "impossible trinity" refers to the impossibility of having simultaneously: (a) Low inflation, high growth and full employment (b) Fixed exchange rate, free capital mobility and independent monetary policy (c) Low taxes, low deficit and high spending (d) Exports, imports and investment Ans: (b).