The exchange rate of the Indian rupee against the US dollar has reached 85 points. In other words, 85 rupees will be paid to buy 1 dollar. In April, this “exchange rate” was around 83 and a decade ago, when Prime Minister Narendra Modi took office, it was around 61. Thus, the rupee is depreciating against the dollar. To be sure, this is a long-term trend, as Chart 1 shows.
Normally, we buy goods (like a pizza or a car) and services (like a haircut or a hotel stay in a hill station) using our money – the Indian rupee. But there are many things where we need things from outside the country – an American-made car or a Swiss vacation or indeed, crude oil. For all such goods and services we may need to purchase US (Dollar) or Swiss currency (Euro) using our home currency before purchasing the final item. The exchange rate between currencies is the exchange rate at which the currency is exchanged. In other words, how many rupees will buy you a dollar or euro.
In such a market – also called a money market – each currency is like a commodity. The value of each currency relative to another currency is called the exchange rate. These values may remain the same over time, but often they change.
What determines the exchange rate?
As with any other business in life, the relative value of one currency over another depends on whether it is in high demand. If Indians demand more US dollars than Americans demand Indian rupees, the exchange rate will tilt in favor of the US dollar; That is, the US dollar will be relatively more valuable, more valuable, and more expensive. If this situation repeats itself every day, such a trend will strengthen and the value of the rupee will fall against the US dollar. This movement will be reflected in the exchange rate of the rupee Weak against the dollar.
But what factors determine the demand for the rupee against the dollar?
There are many factors that can affect the demand for currencies.
A large part of the demand comes from trade in goods. For the sake of simplicity, imagine a world where there are only two countries – India and America. If India imports more goods from the US than it exports to the US, the demand for the US dollar will exceed the demand for the Indian rupee. This, in turn, will strengthen the US dollar against the rupee and increase its exchange rate against the rupee. Conversely, the rupee’s exchange rate against the dollar will weaken. Consequently, more rupees will be needed to buy one US dollar.
Another big component is business in service. If Indians buy more American services—say, tourism—than Americans buy Indian services, again, demand for dollars will outstrip demand for the rupee, and the rupee will weaken.
The third party is investment. If Americans invest more in India than Indians invest in the US, demand for the rupee will be greater than the dollar and the value of the rupee will rise against the dollar.
These are the three main ways that exchange rates can change.
But what factors affect these three types of demand?
Of course, there are many factors that can affect these three demands.
Suppose US decides not to allow Indian imports. In such a situation, the demand for the Indian rupee will decrease. After all, if Americans can’t buy Indian goods, why would they go to the currency market to buy Indian rupees?
End result: Rupee will weaken. As President-elect Donald Trump promised, the US is expected to impose high tariffs on Indian goods and make them so expensive that no one will buy them in the US.
Similarly, imagine a scenario where both India and the US are experiencing high inflation. By definition, inflation erodes the value of a currency because an inflation of 5% means that what can be bought for Rs 100 in the first year requires Rs 105 to buy in the second year.
Now imagine that over a period of five years, the US reduces its inflation to zero while in India it remains at 6%. This means that if an American decides to invest in the Indian stock market thinking that Indian companies/shares will return 10% per annum, he will only get a 4% real return because 6 of those 10% will be. Inflation ate away. On the other hand, the US stock market may give only 5 percent return, but since inflation is at zero percent, the final return will be 5 percent.
In such a case, an investor cannot make any new investment in India; Worse, he could actually withdraw money from India and invest it in America. Both these actions will reduce the demand for the rupee against the dollar and weaken the rupee against the dollar. The same is happening now when investors are withdrawing money from India.
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