INTRODUCTION

EXCHANGE RATE
In finance, an exchange rate (also known as a foreign-exchange rate, forex rate,
FX rate or Agio) between two currencies is the rate at which one currency will be
exchanged for another. It is also regarded as the value of one countrys currency
in terms of another currency. For example, an interbank exchange rate of 91
Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be
exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange
rates are determined in the foreign exchange market, which is open to a wide
range of different types of buyers and sellers where currency trading is
continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on
Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current
exchange rate. The forward exchange rate refers to an exchange rate that is quoted
and traded today but for delivery and payment on a specific future date. In the
retail currency exchange market, a different buying rate and selling rate will be
quoted by money dealers. Most trades are to or from the local currency. The
buying rate is the rate at which money dealers will buy foreign currency, and the
selling rate is the rate at which they will sell the currency. The quoted rates will
incorporate an allowance for a dealer's margin (or profit) in trading, or else the
margin may be recovered in the form of a "commission" or in some other way.
Different rates may also be quoted for cash (usually notes only), a documentary
form (such as traveler's cheques) or electronically (such as a credit card purchase).
The higher rate on documentary transactions has been justified to compensate for
the additional time and cost of clearing the document, while the cash is available
for resale immediately. Some dealers on the other hand prefer documentary
transactions because of the security concerns with cash.

RETAIL EXCHANGE MARKET

People may need to exchange currencies in a number of situations. For example,
people intending to travel to another country may buy foreign currency in a bank
in their home country, where they may buy foreign currency cash, traveler's
cheques or a travel-card. From a local money changer they can only buy foreign
cash. At the destination, the traveller can buy local currency at the airport, either
from a dealer or through an ATM. They can also buy local currency at their hotel,
a local money changer, through an ATM, or at a bank branch. When they purchase
goods in a store and they do not have local currency, they can use a credit card,
which will convert to the purchaser's home currency at its prevailing exchange
rate. If they have travellers cheques or a travel card in the local currency, no
currency exchange is necessary. Then, if a traveller has any foreign currency left
over on their return home, they may want to sell it, which they may do at their
local bank or money changer. The exchange rate as well as fees and charges can
vary significantly on each of these transactions, and the exchange rate can vary
from one day to the next.
There are variations in the quoted buying and selling rates for a currency between
foreign exchange dealers and forms of exchange, and these variations can be
significant.

QUOTATION
A currency pair is the quotation of the relative value of a currency unit against the
unit of another currency in the foreign exchange market. The quotation EUR/USD
1.3533 means that 1 Euro is able to buy 1.3533 US dollar. In other words, this is
the price of a unit of Euro in US dollar. Here, EUR is called the "Fixed currency",
while USD is called the "Variable currency".
There is a market convention that determines which is the fixed currency and
which is the variable currency. In most parts of the world, the order is: EUR
GBP AUD NZD USD others.

FLUCTUATIONS IN EXCHANGE RATE

A market-based exchange rate will change whenever the values of either of the
two component currencies change. A currency will tend to become more valuable
whenever demand for it is greater than the available supply. It will become less
valuable whenever demand is less than available supply (this does not mean
people no longer want money, it just means they prefer holding their wealth in
some other form, possibly another currency).
Increased demand for a currency can be due to either an increased transaction
demand for money or an increased speculative demand for money. The
transaction demand is highly correlated to a country's level of business activity,
gross domestic product (GDP), and employment levels. The more people that are
unemployed, the less the public as a whole will spend on goods and services.
Central banks typically have little difficulty adjusting the available money supply
to accommodate changes in the demand for money due to business transactions.
Speculative demand is much harder for central banks to accommodate, which they
influence by adjusting interest rates. A speculator may buy a currency if the return
(that is the interest rate) is high enough. In general, the higher a country's interest
3

rates, the greater will be the demand for that currency. It has been argued that such
speculation can undermine real economic growth, in particular since large
currency speculators may deliberately create downward pressure on a currency by
shorting in order to force that central bank to buy their own currency to keep it
stable. (When that happens, the speculator can buy the currency back after it
depreciates, close out their position, and thereby take a profit.)
For carrier companies shipping goods from one nation to another, exchange rates
can often impact them severely. Therefore, most carriers have a CAF (Currency
Adjustment Factor) charge to account for these fluctuations.

PURCHASING POWER OF CURRENCY

The real exchange rate (RER) is the purchasing power of a currency relative to
another at current exchange rates and prices. It is the ratio of the number of units
of a given country's currency necessary to buy a market basket of goods in the
other country, after acquiring the other country's currency in the foreign exchange
market, to the number of units of the given country's currency that would be
necessary to buy that market basket directly in the given country. There are
different kind of measurement for RER.
Thus the real exchange rate is the exchange rate times the relative prices of a
market basket of goods in the two countries. For example, the purchasing power
of the US dollar relative to that of the euro is the dollar price of a euro (dollars per
euro) times the euro price of one unit of the market basket (euros/goods unit)
divided by the dollar price of the market basket (dollars per goods unit), and
hence is dimensionless. This is the exchange rate (expressed as dollars per euro)
times the relative price of the two currencies in terms of their ability to purchase
units of the market basket (euros per goods unit divided by dollars per goods
unit). If all goods were freely tradable, and foreign and domestic residents
purchased identical baskets of goods, purchasing power parity (PPP) would hold
4

for the exchange rate and GDP deflators (price levels) of the two countries, and
the real exchange rate would always equal 1.
The rate of change of this real exchange rate over time equals the rate of
appreciation of the euro (the positive or negative percentage rate of change of the
dollars-per-euro exchange rate) plus the inflation rate of the euro minus the
inflation rate of the dollar.

MANIPULATION OF EXCHANGE RATES

A country may gain an advantage in international trade if it controls the market
for its currency to keep its value low, typically by the national central bank
engaging in open market operations. The People's Republic of China has been
acting this way over a long period of time.
Other nations, including Iceland, Japan, Brazil, and so on also devalue their
currencies in the hopes of reducing the cost of exports and thus bolstering their
economies. A lower exchange rate lowers the price of a country's goods for
consumers in other countries, but raises the price of imported goods and services,
for consumers in the low value currency country.
In general, a country that exports goods and services will prefer a lower value on
their currencies, while a country that imports goods and services will prefer a
higher value on their currencies.

SIGNIFICANCE OF THE STUDY

Exchange rate between two currencies is that rate at which one currency will be
exchanged with another currency. It is also known as a foreign-exchange rate,
forex rate. It is regarded as the value of one countrys currency in terms of
another currency. The spot exchange rate is the current exchange rate. The
forward exchange rate is that exchange rate which is quoted today but delivery
and payment settlement will be held on a specific future date. A market-based
exchange rate will change whenever the values of either of the two component
currencies change. A currency tends to become more valuable whenever demand
for it is greater than the available supply
Indian rupee was connected to British pound from 1950 to 1973. On 24th
September 1975, the connection between Indian rupee and pound was broken
down and rupee ties to the pound sterling were disengaged. A float exchange
regime was established by India. Effective rate of rupee was placed on a
controlled, floating basis and linked to a

trading

partners of India. In 1993 Liberalized exchange rate system (LERMS) was

replaced by the unified exchange rate system and a system of market determined
exchange rate was adopted. However, the RBI did not relinquish its power to
intervene in the market to control the Indian currency.
In India a series of economic reforms including liberalization of foreign capital
inflows were initiated since the early nineties. Foreign exchange market has
emerged as the largest market in the world and the breakdown of the Bretton
Woods system in 1971 marked the beginning of floating exchange rate regimes in
several countries. The focus was given to wide ranging reforms of widening and
deepening the foreign exchange market and liberalization of exchange control.
The Forex rates are determined by market forces and are based on demand &
supply of these currencies. If supply exceeds the demand, the value of the
currency depreciates.
-

International, national and scenario

6

In this study with analysis and interpretation of exchange rate

in Export and Import in

India. This is used on the availability of data. Various tools

used for analysis of

Export and Import during the time period from 1981 to 2010.
The tools like Regression (simple linear and semi log linear).

REGRESSION ANALYSIS:
The relationship between the total Exchange Rate and DGP,
simple linear Regression model is used by taking the total
Exchange Rate as the independent variable for the 3 decade
separately. Total Exchange Rate and GDP are measured in
millions of Dollar. The regression co-efficient in this case will
measure the increase in GDP in Millions of Dollars. If the total
Exchange Rate is increased by the one million Dollars. The
regression co-efficient is also tested for the null hypothesis that
its value is zero. The co-efficient determination, R2 will
measure the ability of the independent variable, Total exchange

rate, Import and Export the variation in GDP.

The table shows that the recent of the trend analysis reviled
that the exchange rate in India, increased annual by 0.86
Rupees in 1980-81 to 1989-90. The regression coefficients of
semi linear model implies that the exchange rate, increase at
the compound growth rate of 7.68 percent per year. The
regression, coefficient in both, model at significant 1 percent
model the value of adjusted R2 is 0.96 percent in both models.
In means that the exchange rate have registered the linear trend
in this period, and 97 per cent of variation in the dependent

variables by explain the independent variables.

The results of the trend analysis reviled that the Export in India
has increased annual by 163.21 Millions of US Dollars in
1980-81 to 1989-90. The Regression coefficients of semi log
7

linear model implies that the Export has increased at the

compound growth rate of 5.55 per cent per year.

The

Regression coefficient in both model the significant at1 per

cent level. The value of adjusted R2 is 0.92 per cent in both
model are means that the Export have registered a consistent
linear trend in this period and 94 per cent of variation in the
-

dependent variables by explain the independent variables.

The results of the trend analysis reviled that the Import in
India has increased annual by 864.87 Millions of US Dollars in
1980-81 to 1989-90. The Regression coefficients of semi log
linear model implies that the Import increased at the compound
growth rate of 4.91 per cent per year. The Regression
coefficient in both model are significant at 1 per cent model the
value of adjusted R2 is 0.71 per cent in both model. It means
that the Import have registered the linear trend in this period
and 74per cent of variations dependent variables by explain in

the independent variables.

The results of the trend analysis reviled that the exchange rate
in India, has increased annual by 0.05 Millions of US Dollar in
1990-91 to 1999-2000. The regression coefficients of semi log
linear model implies that the exchange rate has increased at the
compound growth rate of -226.74 per cent per year. The
regression, coefficient in both, models are significant at 1 per
cent level the value of adjusted R2 is 0.86 per cent in both
models. In means that the exchange rate have registered the
linear trend in this period, and 83 per cent of variation in the

dependent variables by explain the independent variables.

The results of the trend analysis reviled that the Export in
India, has increased annual by 242.58 Millions of US Dollars
in 1990-91 to 1999-2000. The Regression coefficients of semi
linear model implies that the Export

has increased at the

compound growth rate of 5.55 per cent per year the Regression
8

coefficient in both model are significant at 1 per cent model the

value of adjusted R2 is 0.95 per cent in both model. It means
that the Export have registered a consistent linear trend in this
period and 95 per cent of variation in the dependent variables
-

by explained the independent variables.

The results of the trend analysis reviled that the Import in
India, has increased annual by 3584.19 Millions of US Dollar
in 1990-91 to 1999-2000. The Regression coefficients of semi
log linear model implies that the Import has increased at the
compound growth rate of 11.29 per cent per year. The
Regression coefficient in both model at significant 1 per cent
model the value of adjusted R2 is 0.97 per cent in both model.
It means that the Import have registered a consistent linear
trend in this period and 96per cent of variations in the

dependent variables by explained by the independent variables.

The results of the trend analysis reviled that the exchange rate
in India, has increased annual by 0.01 Millions of US Dollars
in 2000-01 to 2009-10. The regression coefficients of semi
linear model implies that the exchange rate, increased at the
compound growth rate of 217.04 per cent per year. The
regression, coefficient in both, model are significant at 1 per
cent level. The value of adjusted R2 is 0.86 per cent in both
models. In means that the exchange rate have registered a
consistent linear trend in this period, and 82 per cent of
variation in the dependent variables explained by the

independent variables.
The results of the trend analysis reviled that the Export in
India, has increased annual by 1072.36 Millions of US Dollars
in 2000-01 to 2009-10. The Regression coefficients of semi
log linear model implies that the Export has increased at the
compound growth rate of 11.96 per cent per year. The
Regression coefficient in both model are significant at 1
9

percent level the value of adjusted R2 is 0.92 percent in both

model. It means that the Export have registered a consistent
linear trend in this period and 98 per cent of variations in the
-

dependent variables explained by the independent variables.

The results of the trend analysis reviled that the Import in
India, has increased annual by 121585.87 Millions of US
Dollars in 2000-01 to 200910. The Regression coefficients of
semi log linear model imply that the Import has increased at
the compound growth rate of 33.38 per cent per year. The
Regression coefficient in both model are significant at1 per
cent level the value of adjusted R2 is 0.04 per cent in both
model. It means that the Import have registered a consistent
linear trend in this period and 31per cent of period variations
the dependent variables explained by the independent
variables.

OBJECTIVES OF THE STUDY

1) To understand the concept of Exchange rate and currency fluctuation.
2) To understand the causes for decline of the rupee against dollar.
3)

To study the real implications of the depreciation of the rupee on the

Indian economy
10

4) Different stringent measures by RBI & government to make rupee stronger

5) To propose potential suggestions to overcome the problem.

Concept of currency Appreciation and Depreciation

Impact on

It

is

called

Rupee Rupee APPRECIATES when

DEPRECIATON when

value of a

value of a rupee declines as rupee becomes high as compare

compare to

to

dollar (For an example, when dollar (For example, when US$US$-INR moves from Rs.55/- to INR moves from Rs60/- to Rs
Rs60/
55/Imports become costly as for Imports become cheaper as for
each USD we have to pay Rs5/- each USD we have to pay Rs5
Importers

more

less

IMPORTS
COSTLIER
Exporters will

BECOME IMPORTS
have

BECOME

CHEAPER
higher Exporters will

earn

lower

revenue. For exports of each revenue. For exports of each

Exporters

Dollar, the exporter will get Rs 5 dollar, now the exporter will get
higher

Rs 5 less.

EXPORTERS EARN MORE

EXPORTERS EARN LESS
For each dollar taken abroad For each dollar he intends to
for spending, the travelers has take abroad for spending, the
Indian Who Wish to
Go on
Holidays Abroad and for
Education

to pay Rs 5

travelers has to pay Rs3 less and

more and thus this trip will thus

become costlier

this

trip

will

become

cheaper.

Education & Holiday packages Education

will COSTLIER

packages will
CHEAPER
11

and

Holiday

Sinking Rupee as a big danger for Economy

The prevailing situation is creating internal as well as external threats for the
economy. India may face worst financial crisis if it fails to stop the slide in the
rupee. There is a difficult choice for central bank to best use its limited reserve
and maintain the reliability among foreign investors. The table is showing the
continuous depreciation of Indian rupee with US dollar.

FLEXIBLE EXCHANGE RATE

Flexible exchange rate was experienced by many countries in the form of

adjustable peg system. Different variations of flexible exchange rate were
introduced before and after the second world war.

Floating exchange rate is one of the forms of flexible exchange rate. Under this
system the exchange rate is determined in the market by demand and supply
factors. Since 1973, different countries have tried a variety of flexible exchange
rate.

Advantage of Flexible Exchange Rates Flexible exchange rate system is claimed to have the following advantages:
1. Independent Monetary Policy:
Under flexible exchange rate system, a country is free to adopt an independent
policy to conduct properly the domestic economic affairs. The monetary policy of
a country is not limited or affected by the economic conditions of other countries.

12

2. Shock Absorber:
A fluctuating exchange rate system protects the domestic economy from the
shocks produced by the disturbances generated in other countries. Thus, it acts as
a shock absorber and saves the internal economy from the disturbing effects from
abroad.
3. Promotes Economic Development:
The flexible exchange rate system promotes economic development and helps to
achieve full employment in the country. The exchange rates can be changed in
accordance with the requirements of the monetary policy of the country to achieve
the planned national objectives.
4. Solutions to Balance of Payment Problems:
The system of flexible exchange rates automatically removes the disequilibrium
in the balance of payments. When, there is deficit in the balance of payments, the
external value of a country's currency falls. As a result, exports are encouraged,
and imports are discouraged thereby, establishing equilibrium in the balance of
payment.

5. Promotes International Trade:

The system of flexible exchange rates does not permit exchange control and
promotes free trade. Restrictions on international trade are removed and there is
free movement of capital and money between countries.
6. Increase in International Liquidity:

13

The system of flexible exchange rates eliminates the need for official foreign
exchange reserves, if the individual governments do not employ stabilization
funds to influence the rate. Thus, the problem of international liquidity is
automatically solved. In fact, the present shortage of international liquidity is due
to pegging the exchange rates and the intervention of the IMF authorities to
prevent fluctuations in the rates beyond a narrow limit.
7. Market Forces at Work:
Under the flexible exchange rate system, the foreign exchange rates are
determined by the market forces of demand and supply. Market is cleared off
automatically through changes in exchange rates and the possibility of scarcity or
surplus of any currency does not exist.
8. International Trade not Promoted by Fixed Rates:
The argument that fixed exchange rates promotes international trade is not
supported by historical facts of inter-war or post-war period. On the other hand
under the flexible exchange rate system, the trend of the rate of exchange is
generally assessed through the forward market, and the traders are protected from
financial losses arising from fluctuating exchange rates. This helps in promoting
international trade.

9. International Investment not Promoted by Fixed Rates:

The argument that long-term international investments are encouraged under fixed
exchange rate system is not valid. Both the lenders and borrowers cannot expect
the exchange rate to remain stable over a very long-period.
10. Fixed Rates not Necessary for currency Area:
14

This stable exchange rates are not necessary for any system of currency areas. The
sterling block functioned smoothly during the thirties in spite of the fluctuating
rates of the member countries.
11. Speculation not Prevented by Fixed Rates:
The main weakness of the stable exchange rate system is that in spite of the strict
exchange control, currency speculation is encouraged. This destroys the stability
in the exchange value of the home currency and makes devaluation of the
currency inevitable. For instance, the pound had to be devalued in 1949 mainly
because of such speculation.

Disadvantage of Flexible Exchange Rates

The following are the main drawbacks of the system of flexible exchange rates :
1. Low Elasticities:
The elasticities in the international markets are too low for exchange rate,
variations to operate successfully in bringing about automatic equilibrating
adjustments. When import and export elasticities are very low, the exchange
market becomes unstable. Hence, the depreciation of the weak currency would
simply tend to worsen the balance of payments deficit further.

2. Unstable conditions:
Flexible exchange rates create conditions of instability and uncertainty which, in
turn, tend to reduce the volume of international trade and foreign investment.
Long-term foreign investments arc greatly reduced because of higher risks
involved.

15

3. Adverse Effect on Economic Structure:

The system of flexible exchange rates has serious repercussion on the economic
structure of the economy. Fluctuating exchange rates cause changes in the price of
imported and exported goods which, in turn, destabilise the economy of the
country.
4. Unnecessary Capital Movements:
The system of fluctuating exchange rates leads to unnecessary international
capital movements. By encouraging speculative activities, such a system causes
large-scale capital outflows and inflows, thus, seriously disturbing the economy of
the country.
5. Depression Effects of Capital Movements:
Speculative capital movements caused by fluctuating exchange rates may lead to
the problem of extremely high liquidity preference. In a situation of high liquidity
preference, people tend to hoard currency, interest rates rise, investment falls and
there is large-scale unemployment in the economy.
6. Inflationary Effect:
Flexible exchange rate system involves greater possibility of inflationary effect of
exchange depreciation on domestic price level of a country. Inflationary rise in
prices leads to further depreciation of the external value of the currency.
7. Factor Immobility:
The immobility of various factors of production deprives the flexible exchange
rate system of its advantages arising from the adoption of monetary and other
policies for maintaining internal stability. Such policies produce desirable effects
on production and employment only when supply of factors of production is
elastic.
16

8. Failure of Flexible Rate System:

Experience of the flexible exchange rate system adopted between the two world
wars has shown that it was a flop.

FIXED EXCHANGE RATE SYSTEM A fixed exchange rate, sometimes called a pegged exchange rate, is a type of
exchange rate regime where a currency's value is fixed against either the value of
another single currency, to a basket of other currencies, or to another measure of
value, such as gold. There are benefits and risks to using a fixed exchange rate. A
fixed exchange rate is usually used in order to stabilize the value of a currency by
directly fixing its value in a predetermined ratio to a different, more stable or
more internationally prevalent currency (or currencies), to which the value is
pegged. In doing so, the exchange rate between the currency and its peg does not
change based on market conditions, the way floating currencies will do. This
makes trade and investments between the two currency areas easier and more
predictable, and is especially useful for small economies in which external trade
forms a large part of their GDP.
A fixed exchange-rate system can also be used as a means to control the
behaviour of a currency, such as by limiting rates of inflation. However in doing
so, the pegged currency is then controlled by its reference value. As such, when
the reference value rises or falls, it then follows that the value(s) of any currencies
pegged to it will also rise and fall in relation to other currencies and commodities
with which the pegged currency can be traded. In other words, a pegged currency
is dependent on its reference value to dictate how its current worth is defined at
any given time. In addition, according to the MundellFleming model, with
perfect capital mobility, a fixed exchange rate prevents a government from using
domestic monetary policy in order to achieve macroeconomic stability.

17

Advantages of Fixed Exchange Rates

The main arguments advanced in favour of the system of fixed or stable exchange
rates are as follows:
1. Promotes International Trade:
Fixed or stable exchange rates ensure certainty about the foreign payments and
inspire confidence among the importers and exporters. This helps to promote
international trade.
2. Necessary for Small Nations:
Fixed exchange rates are even more essential for the smaller nations like the U.K.,
Denmark, Belgium, in whose economies foreign trade plays a dominant role.
Fluctuating exchange rates will seriously affect the process of economic growth in
these economies.
3. Promotes International Investment:
Fixed exchange rates promote international investments. If the exchange rates
are fluctuating, the lenders and investors will not be prepared to lend for longterm investments.

4. Removes Speculation:
Fixed exchange rates eliminate the speculative activities in the international
transactions. There is no possibility of panic flight of capital from one country to
another in the system of fixed exchange rates.
5. Necessary for Small Nations:
Fixed exchange rates are even more essential for the smaller nations like the U.K.,
Denmark, Belgium, in whose economies foreign trade plays a dominant role.
18

Fluctuating exchange rates will seriously disturb the process of economic growth
of these economies.
6. Necessary for Developing Countries:
Fixed exchanges rates are necessary and desirable for the developing countries for
carrying out planned development efforts. Fluctuating rates disturb the smooth
process of economic development and restrict the inflow of foreign capital.
7. Suitable for Currency Area:
A fixed or stable exchange rate system is most suitable to a world of currency
areas, such as the sterling area. If the exchange rates of the countries in the
common currency area are flexible, the fluctuations in the leading country, like
England (whose currency dominates), will also disturb the exchange rates of the
whole area.
8. Economic Stabilization:
Fixed foreign exchange rate ensures internal economic stabilization and checks
unwarranted changes in the prices within the economy. In a system of flexible
exchange rates, the liquidity preference is high because the businessmen will like
to enjoy wind fall gains from the fluctuating exchange rates. This tends to
Increase price and hoarding activities in country.
9. Not Permanently Fixed:
Under the fixed exchange rate system, the exchange rate does not remain fixed or
is permanently frozen. Rather the rate is changed at the appropriate time to correct
the fundamental disequilibrium in the balance of payments.
10. Other Arguments:

19

Besides, the fixed exchange rate system is also beneficial on account of the
following reasons.
(i) It ensures orderly growth of world's money and capital markets and regularises
the international capital movements.
(ii) It ensures smooth functioning of the international monetary system. That is
why, IMF has adopted pegged or fixed exchange rate system.
(iii) It encourages multilateral trade through regional cooperation of different
countries.
(iv)In modern times when economic transactions and relations among nations
have become too vast and complex, it is more useful to follow a fixed exchange
rate system.
Disadvantages of Fixed Exchange Rates
The system of fixed exchange rates has been criticized on the following grounds:
1. Outmoded System:
Fixed exchange rate system worked successfully under the favorable conditions of
gold standard during 19th century when
(a) the countries permitted the balance of payments to influence the domestic
economic policy;
(b) there was coordination of monetary policies of the trading countries;
(c) the central banks primarily aimed at maintaining the external value of the
currency in their respective countries; and
(d) the prices were more flexible. Since all these conditions are absent today, the
smooth functioning of the fixed exchange rate system is not possible.

20

2. Discourage Foreign Investment:

Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system
discourages long-term foreign investment which is considered available under the
really fixed exchange rate system.
3. Monetary Dependence:
Under the fixed exchange rate system, a country is deprived of its monetary
independence. It requires a country to pursue a policy of monetary expansion or
contraction in order to maintain stability in its rate of exchange.
4. Cost-Price Relationship not Reflected:
The fixed exchange rate system does not reflect the true cost-price relationship
between the currencies of the countries. No two countries follow the same
economic policies. Therefore the cost-price relationship between them go on
changing. If the exchange rate is to reflect the changing cost-price relationship
between the countries, it must be flexible.
5. Not a Genuinely Fixed System:
The system of fixed exchange rates provides neither the expectation of
permanently stable rates as found in the gold standard system, nor the continuous
and sensitive adjustment of a freely fluctuating exchange rate.

6. Difficulties of IMF System:

The system of fixed or pegged exchange rates, as followed by the International
Monetary Fund (IMF), is in reality a system of managed flexibility.
It involves certain difficulties, such as deciding as to

21

(a) when to change the external value of the currency,

(b) what should be acceptable criteria for devaluation; and
(c) how much devaluation is needed to reestablish equilibrium in the balance of
payments of the devaluing country.

Results and discussion

PURCHASING POWER OF CURRENCY
The real exchange rate (RER) is the purchasing power of a currency relative to
another at current exchange rates and prices. It is the ratio of the number of units
22

of a given country's currency necessary to buy a market basket of goods in the

other country, after acquiring the other country's currency in the foreign exchange
market, to the number of units of the given country's currency that would be
necessary to buy that market basket directly in the given country. There are
different kind of measurement for RER.
Thus the real exchange rate is the exchange rate times the relative prices of a
market basket of goods in the two countries. For example, the purchasing power
of the US dollar relative to that of the euro is the dollar price of a euro (dollars per
euro) times the euro price of one unit of the market basket (euros/goods unit)
divided by the dollar price of the market basket (dollars per goods unit), and
hence is dimensionless. This is the exchange rate (expressed as dollars per euro)
times the relative price of the two currencies in terms of their ability to purchase
units of the market basket (euros per goods unit divided by dollars per goods
unit). If all goods were freely tradable, and foreign and domestic residents
purchased identical baskets of goods, purchasing power parity (PPP) would hold
for the exchange rate and GDP deflators (price levels) of the two countries, and
the real exchange rate would always equal 1.
The rate of change of this real exchange rate over time equals the rate of
appreciation of the euro (the positive or negative percentage rate of change of the
dollars-per-euro exchange rate) plus the inflation rate of the euro minus the
inflation rate of the dollar.

MANIPULATION OF EXCHANGE RATES

A country may gain an advantage in international trade if it controls the market
for its currency to keep its value low, typically by the national central bank
engaging in open market operations. The People's Republic of China has been
acting this way over a long period of time.
23

Other nations, including Iceland, Japan, Brazil, and so on also devalue their
currencies in the hopes of reducing the cost of exports and thus bolstering their
economies. A lower exchange rate lowers the price of a country's goods for
consumers in other countries, but raises the price of imported goods and services,
for consumers in the low value currency country.
In general, a country that exports goods and services will prefer a lower value on
their currencies, while a country that imports goods and services will prefer a
higher value on their currencies.

FACTORS INFLUENCING EXCHANGE RATES

Aside from factors such as interest rates and inflation, the exchange rate is one of
the most important determinants of a country's relative level of economic health.
Exchange rates play a vital role in a country's level of trade, which is critical to
most every free market economy in the world. For this reason, exchange rates are
among the most watched, analyzed and governmentally manipulated economic
measures. But exchange rates matter on a smaller scale as well: they impact the
real return of an investor's portfolio. Following are some of the major forces
behind exchange rate movements
Before we look at these forces, we should sketch out how exchange rate
movements affect a nation's trading relationships with other nations. A higher
currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets. A higher exchange rate can be
expected to lower the country's balance of trade, while a lower exchange rate
would increase it.

24

Determinants of Exchange RatesNumerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and
are expressed as a comparison of the currencies of two countries. The following
are some of the principal determinants of the exchange rate between two
countries. Note that these factors are in no particular order; like many aspects of
economics, the relative importance of these factors is subject to much debate.

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate
exhibits a rising currency value, as its purchasing power increases relative
to other currencies. During the last half of the twentieth century, the
countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those
countries with higher inflation typically see depreciation in their currency
in relation to the currencies of their trading partners. This is also usually
accompanied by higher interest rates.

2. Differentials in Interest RatesInterest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both
inflation and exchange rates, and changing interest rates impact
inflation and currency values. Higher interest rates offer lenders in an
economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise.
The impact of higher interest rates is mitigated, however, if inflation in
the country is much higher than in others, or if additional factors serve
25

to drive the currency down. The opposite relationship exists for

decreasing interest rates - that is, lower interest rates tend to decrease
exchange rates.

3. Current-Account Deficits The current account is the balance of trade between a country and its
trading partners, reflecting all payments between countries for goods,
services, interest and dividends. A deficit in the current account shows
the country is spending more on foreign trade than it is earning, and
that it is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it
receives through sales of exports, and it supplies more of its own
currency than foreigners demand for its products. The excess demand
for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets
are too expensive to generate sales for domestic interests.

4. Public Debt Countries will engage in large-scale deficit financing to pay for public
sector projects and governmental funding. While such activity
stimulates the domestic economy, nations with large public deficits
and debts are less attractive to foreign investors. The reason? A large
debt encourages inflation, and if inflation is high, the debt will be
serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to
pay part of a large debt, but increasing the money supply inevitably
causes inflation. Moreover, if a government is not able to service its
deficit through domestic means (selling domestic bonds, increasing the
26

money supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may
prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great.
For this reason, the country's debt rating (as determined by Moody's or
Standard & Poor's, for example) is a crucial determinant of its
exchange rate.

5.

Terms of Trade A ratio comparing export prices to import prices, the terms of trade is
related to current accounts and the balance of payments. If the price of
a country's exports rises by a greater rate than that of its imports, its
terms of trade have favorably improved. Increasing terms of trade
shows greater demand for the country's exports. This, in turn, results in
rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the
price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong
economic performance in which to invest their capital. A country with
such positive attributes will draw investment funds away from other
countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and
a movement of capital to the currencies of more stable countries.
27

The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived
from any returns. Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from domestic securities.
While exchange rates are determined by numerous complex factors that often
leave even the most experienced economists flummoxed, investors should still
have some understanding of how currency values and exchange rates play an
important role in the rate of return on their investments.

In the present era of increasing globalization and heightened currency volatility,

changes in exchange rates have a substantial influence on companies operations
and profitability. Exchange rate volatility affects not just multinationals and large
corporations, but small and medium-sized enterprises as well, even those who
only operate in their home country. While understanding and managing exchange
rate risk is a subject of obvious importance to business owners, investors should
be familiar with it as well because of the huge impact it can have on their
investments.

Economic or Operating Exposure

Companies are exposed to three types of risk caused by currency volatility:

Transaction exposure This arises from the effect that exchange rate
fluctuations have on a companys obligations to make or receive payments
denominated in foreign currency in future. This type of exposure is shortterm to medium-term in nature.
28

Translation exposure This exposure arises from the effect of currency

fluctuations on a companys consolidated financial statements, particularly
when it has foreign subsidiaries. This type of exposure is medium-term to
long-term.

Economic (or operating) exposure This is lesser known than the

previous two, but is a significant risk nevertheless. It is caused by the
effect of unexpected currency fluctuations on a companys future cash
flows and market value, and is long-term in nature. The impact can be
substantial, as unanticipated exchange rate changes can greatly affect a
companys competitive position, even if it does not operate or sell
overseas. For example, a U.S. furniture manufacturer who only sells
locally still has to contend with imports from Asia and Europe, which may
get cheaper and thus more competitive if the dollar strengthens markedly.

Note that economic exposure deals with unexpected changes in exchange rates which by definition are impossible to predict - since a companys management
base their budgets and forecasts on certain exchange rate assumptions, which
represents their expected change in currency rates. In addition, while transaction
and translation exposure can be accurately estimated and therefore hedged,
economic exposure is difficult to quantify precisely and as a result is challenging
to hedge.
EXCHANGE RISK MANAGEMENTIt is quite common that the exchange rates fluctuate quite often. The fluctuations
are mostly in favour of hard currencies and the advanced countries. The risk is
more in case of developing countries. Therefore, the business organisations
dealing in international business, particularly MNCs should take into
consideration the risks of exchange rate fluctuations while carrying out business
or while investing in foreign markets.
29

The business managers have to manage exchange risk insuring the various
business operations and getting the benefits from the institutions like Export
Credit and Guarantee Corporation. They can make forward transactions in order
to avoid or insure the risk in exchange fluctuations. Several types of transactions
are carried out in a foreign exchange market. Forward transaction is one of the
significant transactions, where a specified amount of one currency is exchanged
for a specified amount of another currency of a future value date. In such a
transaction, only the delivery and payment take place at a future date, the
exchange rates being determined at the time of agreement. The exchange rate
quoted in such a transaction is called a forward rate. Forward exchange rates are
normally quoted for value dates of one, two, three, six and twelve months.
When the payment made for forward delivery is more than the spot delivery of a
foreign currency, the forward contract is said to be at premium, on the other hand,
when the payment for forward delivery is less then the payment for the spot
delivery of a foreign currency, the forward contract is said to be a discount. When
the forward and the spot rates are equal, the forward currency rate is said to be
flat. It is likely that the forward rate would be higher or lower than the current
spot rate on account of interest rate differential, the discount or premium affects
the cost of hedging.

FOREIGN EXCHANGE RISK MANAGEMENT

The foreign exchange is the money in one country for money or credit or goods or
services in another country. The importing country pays to the exporting country
in return of goods or services either in its domestic currency or hard currency.
This currency which facilitates the payment to complete the business transaction
is called foreign exchange. Foreign exchange includes foreign currency, foreign
cheques or foreign drafts. These currencies are bought and sold in foreign
30

exchange markets. The components of foreign exchange market include the

buyers, the sellers and the intermediaries. Foreign exchange market is not
restricted to any place or country. It is the market for currencies of various
countries anywhere in the globe. In recent times, foreign exchange is traded
through online (internet). The market intermediaries of foreign exchange include
banks, brokers, acceptance houses and Central bank of the country. Certain banks
are authorised to deal in foreign exchange. These banks discount and sell foreign
bills of exchange, issue bank drafts, travellers cheques etc. Every business
transaction in international business involves foreign exchange because every
country has its own currency.

MAJOR FINDINGS & POLICY IMPLICATIONS -

31

Exchange rate between two currencies is that rate at which one currency will be
exchanged with another currency. It is also known as a foreign-exchange rate,
forex rate. It is regarded as the value of one countrys currency in terms of
another currency. The spot exchange rate is the current exchange rate. The
forward exchange rate is that exchange rate which is quoted today but delivery
and payment settlement will be held on a specific future date. A market-based
exchange rate will change whenever the values of either of the two component
currencies change. A currency tends to become more valuable whenever demand
for it is greater than the available supply
Indian rupee was connected to British pound from 1950 to 1973. On 24th
September 1975, the connection between Indian rupee and pound was broken
down and rupee ties to the pound sterling were disengaged. A float exchange
regime was established by India. Effective rate of rupee was placed on a
controlled, floating basis and linked to a

trading

partners of India. In 1993 Liberalized exchange rate system (LERMS) was

replaced by the unified exchange rate system and a system of market determined
exchange rate was adopted. However, the RBI did not relinquish its power to
intervene in the market to control the Indian currency.
In India a series of economic reforms including liberalization of foreign capital
inflows were initiated since the early nineties. Foreign exchange market has
emerged as the largest market in the world and the breakdown of the Bretton
Woods system in 1971 marked the beginning of floating exchange rate regimes in
several countries. The focus was given to wide ranging reforms of widening and
deepening the foreign exchange market and liberalization of exchange control.
The Forex rates are determined by market forces and are based on demand &
supply of these currencies. If supply exceeds the demand, the value of the
currency depreciates.
Sinking Rupee as a big danger for Economy

32

The prevailing situation is creating internal as well as external threats for the
economy. India may face worst financial crisis if it fails to stop the slide in the
rupee. There is a difficult choice for central bank to best use its limited reserve
and maintain the reliability among foreign investors. The table is showing the
continuous depreciation of Indian rupee with US dollar.

Exchange Rate INR/ USD

r
a
lo
l
D
/
R
N
I

Series2

2007

2008

2008

2009

2010

2011

2011

2011

2012

2013

2013

2013

(Oct

(June

(Oct

(Oct

(Jan)

(April

(Sept

(Nov)

(May

(June

(June

(July)

38.4

42.51

48.8

46.3

44.17

48.24 55.39

55.99 55.52 60.58

46.2

8
8
7
1
Source: on the basis of RBI exchange rate data.

33

61.04
5

There are many reasons due to which this critical situation came in to economy
and grabbed more attention of RBI and Indian govt. towards this scenario. Some
of the reasons are mentioned below. A number of factors can cause currency
depreciation, i.e. economic, political, corruption etc., but some factors require
greater attention and should be analyzed objectively than the others.
1. Dollar On A Strong Position in global market
The main reason behind rupee fall is the immense strength of the Dollar Index,
which has touched its three-year high level of 84.30. The record setting
performance of US equities and the improvement in the labor market has made
investors more optimistic about the outlook for the US economy.
2. Recession in the Euro Zone Is Back on the move:
The rupee is also feeling the pinch of the recession in the Euro zone. From the
past few months global economy is suffered from Euro crisis, investors are
focused on selling Euros and buying dollars. Any outward flow of currency or a
decrease in investments will put a downward pressure on the rupee exchange rate.
3. Decreasing rating by Rating Agencies & slow growth projection by IMF
Due to uncertainty prevailing in Europe and the slump in the international
markets, investors prefer to stay away from risky investments. The credit rating
agency such as Moody has downgraded the India to BBB with a negative outlook.
IMF also signed 5.6% growth rate for the economy. This global uncertainty has
adversely impacted the domestic factors and could lead to a further depreciation
of the rupee.
4. Pressure

of

increasing

Current Account Deficit:

The country with high exports will be happier with a depreciating currency India,
on the other hand, does not enjoy this because of crude oil and gold consist a
major portion of its import basket. Euro zone, one of India's major trading
partners is under a severe economic crisis. This has significantly impacted Indian

34

exports because of reduced demand. Thus India continues to record a current

account deficit of around 4.3%, depleting its Forex reserves.
5. Impact

of

Commodity Prices in Global Market

As there was a sharp fall in the commodity prices (of gold and crude oil) in global
market still a large part of the import bill is driven by other resources as well. The
facts show that fertilizer imports surged by 30% in the last two years and coal
imports have doubled. The falling commodity prices on the other hand have
increased imports resulting in an imbalance in the rupee value.
6. Speculations

from Exporter

and Importer side

The reason of fall in rupee can be largely attributed to speculations prevailing in

the markets. Due to a sharp increase in the dollar rates, importers suddenly started
gasping for dollars in order to hedge their position, which led to a further demand
for dollars. On the other hand exporters kept on holding their dollar reserves,
speculating that the rupee will fall further in future. This interplay between the
two forces further fuelled the demand for dollars and a fall in rupee.
7. Interest Rate Difference:
Higher real interest rates generally attract foreign investment but due to slowdown
in growth there is increasing pressure on RBI to decrease the policy rates. Under
such conditions foreign investors tend to stay away from investing. This further
affects the capital account flows of India and puts a depreciating pressure on the
currency.
8. Persistent inflation: India has experienced high inflation, above 8%, for
almost two years. If inflation becomes a prolonged one, it leads to overall
worsening of economic prospects and capital outflows and eventual depreciation
of the currency.

35

Challenges in Front of RBI and Indian Govt.:

Bank rate :Due to these fluctuation bank rate raised from 8.25% to
10.25% and Limit of lending overnight borrowing from RBI fixed to
Rs75000cr. This was again a problem as cost of short term borrowing
rise for corporate. This was done to tame inflationary expectations. So
further raising interest rates would lead to lower growth levels.

IMPACT OF EXCHANGE RATE ON TRADE AND GDP FOR INDIA

Real exchange rate is commonly known as a measure of international
competitiveness. It is also known as index of competitiveness of currency of
any country and an inverse relationship between this index and
competitiveness exists. Lower the value of this index in any country, higher
the competitiveness of currency of that country will be.
A country's economic size affects its scale of foreign exchange reserve, so the
influence of GDP is self-evident; the changes of the exchange rate of a
country will cause the fluctuation of foreign trade and then cause the
imbalance of the international balance of payments, thus exchange rate also
influences the scale of the foreign exchange reserve.
The scholars at home and abroad conduct a wide study of the impact of GDP
and exchange rate on the foreign exchange reserve. Beyond seas, the
parameter model designed by Frenkel (l978) constituted a reserve demand
function by regression and correlation analysis of all kinds of, Factors that
influences the demand of foreign exchange reserve of one country including
36

GDP to determine their serve demand. Philip and Burke (2001) considered the
influence of relative factors such as the per capita GDP to the foreign
exchange reserves. Dooley et al. (2005) thought that the foreign exchange
reserve of some countries with a rapid increase is the by-product of the
undervalued real exchange rate policy carried out by them aiming at
promoting the export, not that these national monetary and financial
authorities are intended. Jeanne and Ranciere (2011) also researched the
influence of the actual exchange rate to the optimal reserve. At certain
conditions, the underestimated exchange rate theory led to the trade surplus,
which increases a country's foreign exchange reserve.
Research related to exchange rate management still remains of interest to
economists, especially in developing countries, despite a relatively enormous
body of literature in the area.
This is largely because the exchange rate in whatever concept , is not only an
important relative price, which connects domestic and world markets for
goods and assets, but it also signals the competitiveness of a countrys
exchange power vis--vis the rest of the world in market. Besides, it also
serves as an anchor which supports sustainable internal and external
macroeconomic balances over the medium-to-long term. There is, however,
no simple answer to what determine the equilibrium exchange rate, and
estimating equilibrium exchange rates and the degree of exchange rate
misalignment remains one of the most challenging empirical problems in open
economy macroeconomics (Aliyu, 2008).
Understanding the impact currency depreciation has on a nations trade
balance is crucial to the implementation of successful trade policy. In an
economic climate where countries are focused on improving their output,
often by permitting their currencies to lose value, this topic has become
increasingly important.

37

Standard theory dictates that these countries should be able to improve output
via exports using depreciation as a tool. As currency depreciates imported
goods become more expensive to domestic buyers, while at the same time
exports become less expensive to foreign buyers.
The combination of these relative price changes should result in a positive
movement in a nations trade balance. However, the results of depreciation are
not always consistent with theoretical expectations.

38

CONCLUSION

The above study shows that fluctuations in the exchange rate are common
and it has a great impact on the country. Because the demand for foreign
exchange is due to import of goods or services, investment in foreign countries,
other payments involved by governments, donations, etc. The supply of foreign
exchange of a particular country comes from export of goods and services, inflow
of foreign capital, payments made by foreign governments, remittances by NRIs,
donations etc. The excess demand over supply results in the exchange rate higher
than the equilibrium exchange rate and vice versa. Thus, exchange rate is purely
determined by the market conditions of demand for and supply of foreign
exchange.
Thus a slight fluctuation in exchange rate can have great implications on
the economy of a nation as a whole. Therefore RBI needs to take appropriate
measures to reduce the repercussions of exchange rate fluctuations.

39