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Exchange Rates : Balance of Payments

Economics -II Balance of Payments

Balance of Payments Theory and Foreign Exchange Rate

Meaning and Types of Exchange Rate

Meaning:

Exchange rate between the countries is the price at which residents of two countries trade with each other or the rate at which one currency is exchanged for another. Exchange Rate between US $ and Indian Rupee is Rs. 48 /$. It means 1 $ can be exchanged for Rs. 48 in the world market for foreign currency. If an Indian wants to buy $ he will have to pay Rs. 48 for each $ he has bought. If an American wants to buy Rs. he will get Rs. 48 for each $ he has paid.

Exchange Rate can be explained in two ways:

1 $ can buy Rs. 48. or 1 Re. can buy $ 1/48

Exchange rate is 48 Rs./$ or 1/48 $/Rs.

Both the ways of expressing the Exchange rate are equivalent. If Exchange rate decreases from 48 Rs./$ to 45 Rs./$ then it is called depreciation of $.

A rise in exchange rate is called an appreciation. When the domestic currency depreciates it buys less of the foreign currency and when it appreciates it buys more.

Types of Exchange Rate:

1. Nominal Exchange Rate (NER)

2. Real Exchange Rate (RER)

Nominal Exchange Rate is the relative price of the currency of 2 countries.

Or, It is the price of foreign currency in terms of domestic currency.

It is the rate at which goods of one country can be traded for goods of another country, also known as terms of trade.

e.g. 1 $ = Rs. 40

It means 1 $ can be exchanged for Rs. 40

Real Exchange Rate sometimes called as the terms of trade is the relative price of the goods of 2 countries. It tells us the rate at which we can trade the goods of one country for the goods of other country.

The balance of payments theory of foreign exchange rate in India.

It will be understood from above that the various items in the country’s balance of payments lie at the back of demand for and supply of a foreign currency.That is why the explanation of determination of foreign exchange rate through demand and supply is also called the Balance of Payments Theory of Foreign Exchange.

The demand for foreign exchange arises from the debit items in the balance of payments, whereas the supply of foreign exchange arises from credit items. The debit items relate to all payments made during a given period by residents of a country to foreigners, and credit items include all payments received during the given period from foreigners by the residents. These payments may be on any account, e.g. goods bought and sold, services rendered and received, capital borrowed or lent, and so on. By way of illustration, if India has a net debit in its balance of payments, its demand for foreign exchange, say, U.S. dollar, must exceed its supply of U.S. dollar with the result that the rupee price of U.S. dollar will go up or, what comes to the same thing, the external value of the rupee must go down in terms of dollar.

The rupee becomes cheap in terms of dollar. Conversely, a net credit in India’s balance of payments will lead to a fall in the rupee-price of dollar, which means a higher value of the rupee or expensive rupee in terms of US dollar. When the balance of payments is in deficit, the country will have a weak exchange rate position. There will be increase in the demand for foreign exchange relative to the supply thereof because more payments have to be made than receipt of payments from abroad.

In this case there will be decline in the external value of the domestic currency. But the depreciated external value of its If a country has a surplus on current account, it is said to have a favourable balance of payments. There are more people abroad who have to make payments to this country. The demand for this country’s currency will increase on the part of the holders of foreign currency. The result will be that the external value of the domestic currency will appreciate. This is how the balance of payments affecting demand for foreign exchange and supply of foreign exchange determines the rate of exchange.

The explanation of foreign exchange through demand or what sometimes is called balance of payments theory of exchange rates is superior because:

(a) It is more realistic as the price of foreign currency is seen here as a function of many significant variables and not merely purchasing power expressed in general price level, and

(b) It clearly shows the possibility of correcting balance of payments disequilibrium through exchange rate adjustment rather than through domestic price deflation as implied by the purchasing power parity.

The chief merit of demand-supply approach to the determination of exchange rate or what is sometimes called balance of payments theory of foreign exchange is that it explains the determination of foreign exchange rate through general demand and supply analysis.

Further, important fact brought out by the theory is that not only exports and imports of goods but also other items in the balance of payments such as invisible items, long-term capital movements also play a significant part in determining demand for and supply of foreign exchange and the equilibrium rate of exchange.

Thus, this theory puts forward more correct explanation of the determination of foreign exchange rate by visualizing foreign exchange as a function of several variables and not just purchasing power representing the general price level. This theory also highlights an important fact that disequilibrium in the balance of payments, if left to the market forces, can be corrected through depreciation or appreciation in exchange rate.

Four ways to determine the rate of foreign exchange are:

(a) Demand for foreign exchange (currency)

(b) Supply of foreign exchange

(d) Change in Exchange Rate

In a system of flexible exchange rate, the exchange rate of a currency (like price of a good) is freely determined by forces of market demand and supply of foreign exchange.

Expressed graphically the Intersection of demand and the supply curves determines the equilibrium exchange rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market).

Let us assume that there are two countries—India and USA—and the exchange rate of their currencies, viz., rupee and dollar are to be determined. Presently there is floating or flexible exchange regime in both India and USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.

(a) Demand for foreign exchange (currency):

Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to undertake foreign tours, (vi) to make payment of international trade, etc. The demand for dollars varies inversely with rupee price of dollar, i.e., higher the price, the lower is the demand. The demand curve in Fig. 10.1 is downward sloping because there is inverse relationship between foreign exchange rate and its demand.

(b) Supply of foreign exchange:

Supply of foreign exchange conies.

(i) when foreigners purchase home country’s (say, India’s) goods and services through our exports

(ii) when foreigners make direct investment in bonds and equity shares of home country

(iii) when speculation causes inflow of foreign exchange

(iv) when foreign tourists come to home country

The supply curve is upward sloping (vide Fig. 10.1) because there is direct relationship between foreign exchange rate and its supply.

(c) Determination of exchange rate:

This is determined at a point where demand for and supply of foreign exchange are equal. Graphically, intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency. At any particular time, the rate of foreign exchange must be such at which quantity demanded of foreign currency is equal to quantity supplied of that currency. It is proved with the help of the following diagram. The price on the vertical axis is stated in terms of domestic currency (i.e., how many rupees for one US dollar).

The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars). In this figure, demand curve is downward sloping which shows that less foreign exchange is demanded when exchange rate increases (i.e., inverse relationship). The reason is that rise in the price of foreign exchange (dollar) increases the rupee cost of foreign goods which makes them more expensive. The result is fall in imports and demand for foreign exchange.

The supply curve is upward sloping which implies that supply of foreign exchange increases as the exchange rate increases (i.e., direct relationship). Home country’s goods (here Indian goods) become cheaper to foreigners because rupee is depreciating in value.

As a result, demand for Indian goods increases. Thus, our exports should increase as the exchange rate increases. This will bring greater supply of foreign exchange. Hence, the supply of foreign exchange increases as the exchange rate increases which proves the slope of supply curve.

In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at point E which implies that at exchange rate of OR (QE), quantity demanded and supplied are equal (both being equal to OQ). Hence, equilibrium exchange rate is OR and equilibrium quantity is OQ.

(d) Change in Exchange Rate:

Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply remaining the same, will cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange rate, i.e., exchange rate (price of dollar in terms of rupees) will rise from OR to OR, (say, 1 dollar = 52 rupees). It shows depreciation of Indian currency (rupees) because more rupees (say, 52 instead of 50) are required to buy 1 US dollar. Thus, depreciation of currency means a fall in the price of home currency.

Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result exchange rate will fall from OR to OR2. It indicates appreciation of Indian currency (rupees) because cost of US dollar in terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less rupees are required to buy 1 US dollar or now Rs 48 instead of Rs 50 can buy 1 dollar. Thus, appreciation of currency means ‘a rise in the price of home currency’.

Exchange Rate Determination

If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive in terms of Indian rupee. This suggests that domestic trade is conducted in terms of domestic currency. But if the Indian shawl- maker decides to go abroad, he must exchange Indian rupee into franc or dollar or pound or euro.

To facilitate this exchange form, banking institutions appear. Indian shawlmaker will then go to a bank for foreign currencies. The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be exchanged for foreign currencies. Thus, foreign currencies are required in the conduct of international trade. In a foreign exchange market comprising commercial banks, foreign exchange brokers and authorised dealers and the monetary authority (i.e., the RBI), one currency is converted into another currency.

A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus, an exchange rate can be regarded as the price of one currency in terms of another. An exchange rate is a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian goods worth Rs. 400 and Rs. 250 then pound- rupee or dollar-rupee exchange rate becomes Rs. 80 = £1 or Rs. 50 = $1, respectively. Exchange rate is usually quoted in terms of rupees per unit of foreign currencies. Thus, an exchange rate indicates external purchasing power of money.

A fall in the external purchasing power or external value of rupee (i.e., a fall in exchange rate, say from Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian rupee. Consequently, an appreciation of the Indian rupee occurs when there occurs an increase in the exchange rate from the existing level to Rs. 78 = £1.

In other words, external value of the rupee rises. This indicates strengthening of the Indian rupee. Conversely, the weakening of the Indian rupee occurs if external value of rupee in terms of pound falls. Remember that each currency has a rate of exchange with every other currency.

Not all exchange rates but about 150 currencies are quoted, since no significant foreign exchange market exists for all currencies. That is why exchange rate of these national currencies are quoted usually in terms of US dollars and euros.

2. Exchange Rate Determination:

Now two pertinent questions that usually arise in the foreign exchange market are to be answered now. Firstly, how is equilibrium exchange rate determined and, secondly, why exchange rate moves up and down. There are two methods of foreign exchange rate determination. One method falls under the classical gold standard mechanism and another method falls under the classical paper currency system. Today, gold standard mechanism does not operate since no standard monetary unit is now exchanged for gold. All countries now have paper currencies not convertible to gold. Under inconvertible paper currency system, there are two methods of exchange rate determination. The first is known as the purchasing power parity theory and the second is known as the demand-supply theory or balance of payments theory. Since today there is no believer of purchasing power parity theory, we consider only demand-supply approach to foreign exchange rate determination.

1. Demand-Supply Approach of Foreign Exchange, Or BOP Theory of Foreign Exchange:

Since the foreign exchange rate is a price, economists apply supply-demand conditions of price theory in the foreign exchange market. A simple explanation is that the rate of foreign exchange equals its supply. For simplicity, we assume that there are two countries: India and the USA. Let the domestic currency be rupee. US dollar stands for foreign exchange and the value of rupee in terms of dollar (or conversely value of dollar in terms of rupee) stands for foreign exchange rate. Now the value of one currency in terms of another currency depends upon demand for and supply of foreign exchange.

(i) Demand for foreign exchange:

When Indian people and business firms want to make payments to the US nationals for buying US goods and services or to make gifts to the US citizens or to buy assets there, the demand for foreign exchange (here dollar) is generated. In other words, Indians demand or buy dollars by paying rupee in the foreign exchange market.

A country releases its foreign currency for buying imports. Thus, what appears in the debit side of the BOP account is the sources of demand for foreign exchange. The larger the volume of imports the greater is the demand for foreign exchange.

The demand curve for foreign exchange is negative sloping. A fall in the price of foreign exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means that foreign goods are now more cheaper.

Thus, an Indian could buy more American goods at a low price. Consequently, imports from the USA would increase resulting in an increase in the demand for foreign exchange, i.e., dollar. Conversely, if the price of foreign exchange or price of dollar rises (i.e., dollar appreciates) then foreign goods will be expensive leading to a fall in import demand and, hence, fall in the demand for foreign exchange.

Since price of foreign exchange and demand for foreign exchange move in opposite direction, the importing country’s demand curve for foreign exchange is downward sloping from left to right.

In Fig. 5.4, DD1 is the demand curve for foreign exchange. In this figure, we measure exchange rate expressed in terms of domestic currency that costs 1 unit of foreign currency (i.e., dollar per rupee) on the vertical axis. This makes demand curve for foreign exchange negative sloping.

If exchange rate is expressed in terms of foreign currency that could be purchased with 1 unit of domestic currency (i.e., dollar per rupee), the demand curve would then exhibit positive slope. Here we have chosen the former one.

(b) Supply of foreign exchange:

In a similar fashion, we can determine supply of foreign exchange. Supply of foreign currency comes from its receipts for its exports. If the foreign nationals and firms intend to purchase Indian goods or buy Indian assets or give grants to the Government of India, the supply of foreign exchange is generated.

In other words, what the Indian exports (both goods and invisibles) to the rest of the world is the source of foreign exchange. To be more specific, all the transactions that appear on the credit side of the BOP account are the sources of supply of foreign exchange.

A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to foreigners in terms of dollars. This will induce India to export more. Foreigners will also find that investment is now more profitable. Thus, a high price or exchange rate ensures larger supply of foreign exchange. Conversely, a low exchange rate causes exchange rate to fall. Thus, the supply curve of foreign exchange, SS1, is positive sloping.

Now we can bring both demand and supply curves together to determine foreign exchange rate. The equilibrium exchange rate is determined at that point where demand for foreign exchange equals supply of foreign exchange. In Fig. 5.4, DD₁ and SS₁ curves intersect at point E. The foreign exchange rate thus determined is OP. At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied (OM). The market is cleared and there is no incentive on the part of the players to change the rate determined.

Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is matched by the supply of foreign exchange. If the current exchange rate OP1 exceeds the equilibrium rate of exchange (OP) there occurs an excess supply of dollar by the amount ‘ab’. Now the bank and other institutions dealing with foreign exchange—wishing to make money by exchanging currency—would lower the exchange rate to reduce excess supply.

Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for foreign exchange by the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP2. Thus, banks would experience a shortage of dollars to meet the demand. Rate of foreign exchange will rise till demand equals supply.

The exchange rate that we have determined is called a floating or flexible exchange rate. (Under this exchange rate system, the government does not intervene in the foreign exchange market.) A floating exchange rate, by definition, results in an equilibrium rate of exchange that will move up and down according to a change in demand and supply forces. The process by which currencies float up and down following a change in demand or change in supply forces is, thus, illustrated in Fig. 5.5.

Let us assume that national income rises. This results in an increase in the demand for imports of goods and services and, hence, demand for dollar rises. This results in a shift in the demand curve from DD1 to DD2. Consequently, exchange rate rises as from OP1 to OP2 determined by the intersection of new demand curve and supply curve. Note that dollar appreciates from Rs. 50 = $1 to Rs. 53 = $1, while rupee depreciates from $1 = Rs. 50 to $1 = Rs. 53.

Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig. 5.6, new exchange rate thus determined would be OP2. If Indian goods are exported more, following an increase in national income of the USA, the supply curve would then shift rightward. Consequently, dollar depreciates and rupee appreciates. New exchange rate is settled at that point where the new supply curve (SS2) intersects the demand curve at E2.

This is the balance of payments theory of exchange rate determination. Wherever government does not intervene in the market, a floating or a flexible exchange rate prevails. Such system may not necessarily be ideal since frequent changes in demand and supply forces cause frequent as well as violent changes in exchange rate. Consequently, an air of uncertainty in trade and business would prevail.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this situation, government intervenes in the foreign exchange rate. It may keep the exchange rate fixed. This exchange rate is called a fixed exchange rate system where both demand and supply forces are manipulated or calibrated by the central bank in such a way that the exchange rate is kept pegged at the old level.

Often managed exchange rate is suggested. Under this system, exchange rate, as usual, is determined by demand for and supply of foreign exchange. But the central bank intervenes in the foreign exchange market when the situation demands to stabilise or influence the rate of foreign exchange. If rupee depreciates in terms of dollar, the RBI would then sell dollars and buy rupee in order to reduce the downward pressure in the exchange rate.

Analysis of Some Exchange Rate Concepts:

As the Indian economy gets more integrated with the world economy (that is, has extensive trade and capital flows with the rest of the world), exchange rate of rupee with foreign currencies will play a very important role as it will determine competitiveness of Indian goods and services in the international markets.

The rupee has different exchange rates with foreign currencies of its various trade partners. A bilateral exchange rate with a foreign currency, say the US dollar, in nominal terms is not a good exchange rate with which to measure the competitiveness of the rupee.

Further, the exchange rate of rupee with a single currency in nominal terms would not measure the differences in changes in prices and costs in the domestic economy as compared to the changes in prices in all the trade partners. To deal with this issue the effective exchange rate (EER) concept is used.

Nominal Exchange Rate (NER):

Foreign exchange rate is generally quoted as the number of units of a domestic currency required to purchase one unit of a foreign currency. For example, rupees 40 per US dollar refers to foreign exchange rate of the Indian rupee in terms of US dollar and means that Rs. 40 can buy one US dollar in foreign exchange market. Likewise, there is foreign exchange rate between rupee and the pound sterling, between rupee and the Yen, between rupee and Mark and so on. This exchange rate of rupees per US dollar, or per pound sterling is called nominal exchange rate (NER).

Nominal Effective Exchange Rate (NEER):

In addition to the nominal exchange rate, the economists often use the concept of nominal effective exchange rate. The nominal effective exchange rate is the weighted average of nominal exchange rates where the weights used are the shares of the trading partners in the foreign trade of a country. Suppose the US accounts for 60 per cent of total trade with India, and the United Kingdom accounts for 40 per cent of trade with India, then the nominal effective exchange rate is given by

Nominal Effective exchange rate (NEER) = (NER_US W_US) + (NER_UK × W_UK)

where NER_US and NER_UK are the nominal exchange rates of the US and UK respectively for the India rupee and W and W are trade shares of the US and UK respectively with India. Suppose the US accounts for 60 per cent in India’s trade and NER of the Indian rupee with the US dollar is Rs.44 while UK accounts for 40 per cent in India’s trade and nominal exchange rate of rupee with pound sterling is Rs.85, the nominal effective exchange rate is

NEER = 44 x 0.6 + 85 × 0.4

= 26.4 + 34.0 = 60.4

Real Exchange Rate:

Real exchange rate measures the relative price of the two currencies after adjusting for price levels prevailing within two countries. For example, real exchange rate between rupee and US dollar is defined as the rupee price of a basket of goods in India relative to a

RER = NER (P_US/P_IN)

where NER is the nominal exchange rate between the two currencies and P_US is the price level in the USA and P_INis the price level in India. While the nominal exchange rate measures the rate at which currencies of the two countries are exchanged, real exchange rate measures the rate at which domestic goods can be exchanged for foreign goods.

An example will clarify the meaning of real exchange rate. Suppose Rs. 44 are required to buy one US dollar, that is t 44 per US dollar is the nominal exchange rate (NER) between the Indian rupee and the US dollar. If a basket of goods costs 200 in India and the same basket of goods costs 20 dollars, then real exchange rate (RER) will be:

RER = (NER)P_US/P_IN = 44 × 20/200 = 4.4

Thus 4.4 is the real exchange rate of the Indian rupee. This means 4.4 units of Indian goods are needed to buy one unit of US goods. Real exchange rate is used as a measure of international competitiveness. A rise in real exchange rate indicates foreign goods (in our example the US goods) have become more expensive relative to domestic goods of a country. This means competitiveness of our goods has increased relative to that of the USA.

Real Effective Exchange Rate (REER):

Real effective exchange rate is the weighted average of real exchange rates with all its trade partners, the shares of different countries in its total trade are used as weights. Thus, in India 5 countries real effective exchange rate (REER) is prepared and the shares of major trade partners such as the USA, UK, other European countries, Japan with India are used as weights for calculating real effective exchange rate.

Changes in India’s Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER):

India’s NEER (base 2000 = 100) which is composed of 5 foreign currencies namely, US dollar, Euro, Pound sterling and Japanese Yen. This India’s NEER depreciated on a yearly basis till 2004-05 to reach a level of 90.75. With a bout of appreciation during April – June 2005, it depreciated thereafter but it again rose during Jan. to Feb. 2006 to 94.06. In 2006-07 it depreciated steadily till Aug. 2006 when it reached a low of 88.05. It once again rose to 91.31 in Nov. 2006. This shows there has been quite a large changes in NEER causing uncertainty about what exchange rate will prevail in future.

As regards the real effective exchange rate (REER), it appreciated to 106.79 in 2005-06. After depreciating to 100.6 in Aug. 2006, it rose to 109.0 in Nov. 2006.

Devaluation and Depreciation of Exchange Rate:

An important issue in regard to foreign exchange rate has been at what level it should be fixed or stabilized. Even under Bretton Woods system 1 per cent change in fixed exchange rate on either side the parity value was allowed to be varied. For more than one per cent change in the exchange rate the permission of IMF was necessary to restore equilibrium in the balance of payments. A proposal was mooted to increase this permissible band for variation or adjustment to be raised to 10 per cent from the parity value to correct disequilibrium in the balance of payments.

However, in 1973 Bretton Woods system of fixed exchange rate collapsed. The US dollar and Pound Sterling were floated, that is, allowed to be determined freely by demand for and supply of these currencies. However, India continued with the fixed exchange rate system. But instead of based on parity value in terms of gold or the US dollar it determined exchange rate of rupee on the basis of exchange rate movements of a basket of foreign currencies, namely, the pound sterling, US dollar, Yen and Mark.

In 1991 India faced a serious balance of payments crisis with stagnant exports and rising imports, especially of petroleum oil. On the advice of IMF India devalued its rupee in July 1991 to solve the balance of payments problem. It was about 25 per cent devaluation against the currencies of our major trading partners. As a result of this devaluation India’s exports increased substantially and also black market in foreign exchange that prevailed before came to end.

In addition to devaluation, a dual exchange rate system was introduced in 1992.

Under the dual exchange rate system there were two rates:

(1) The official exchange rate that was controlled and

(2) The market rate of exchange which was free to change according to demand and supply conditions.

Under this dual exchange rate system 40 per cent of earnings from the exports of goods and services were to be surrendered to RBI through authorized dealers at officially fixed exchange rate. The foreign exchange reserves received in this way was used by RBI for financing preferred imports. The remaining 60 per cent of export earnings in foreign exchange were converted into rupees by the exporters at the market determined exchange rate.

However, in the year 1993-94 the policy of dual exchange rates was dropped and rupee was allowed to float. With this a unified market determined exchange rate came to prevail which can change as a result of changes in demand and supply of foreign currencies.

Managed Float System and Implications of RBI Intervention:

It is important to note that even with the present flexible exchange rate system in India there is a managed float system because RBI intervenes in foreign exchange market to influence the exchange rate of rupee and keep fluctuations in it within reasonable limits.

Thus when rupee in the free market depreciates much and RBI does not want much depreciation, it will sell foreign exchange from its reserves in the foreign exchange market to prevent it from depreciating. On the other hand, when rupee appreciates much against foreign currencies RBI intervenes and buys foreign exchange. This move of RBI prevents rupee from appreciating. Note that appreciation of rupee as compared to other currencies makes the Indian exports expensive and therefore discourages them. Although RBI does not follow any fixed exchange rate target through sale and purchase of foreign exchange, it aims at preventing large volatility in foreign exchange rate of rupee.

However through sale and purchase of foreign exchange by RBI has implications for maintaining price stability. This is because when RBI buys foreign exchange from the market it issues new money (i.e. rupee currency) to pay for it. This new money comes into circulation in the Indian economy and thus leads to the expansion in money supply. If aggregate supply of goods remains the same or does not increase much, this expansion in money will cause rise in general price level (i.e. inflation) in the economy. To check inflation, RBI can sterilize the impact of increase in foreign exchange inflows by selling government securities to the banks.

The banks will give cash to RBI against the purchase of these securities. In this way RBI mops up excess liquidity (i.e. cash reserves) of the banks caused by the inflows of foreign exchange. The proceeds of the government securities sold to the banks can be kept by RBI in a separate account which cannot be used by the Government and therefore cannot affect prices. However, there is limit to which the sterilization can take place. From Aug. 2006 the Indian rupee started appreciating and its exchange rate with US dollar rose to eight year high of Rs. 43 per US on March 28, 2007 and further to f 41.57 on April 23, 2007. In the last four months (Jan-April 2007) RBI did not intervene much to buy foreign exchange from the market and as a result continued inflows of dollars in India resulted in the exchange rate of rupee to appreciate.

On Nov. 12, 2007, the exchange rate of rupee per US $ rose to Rs. 39.4. The RBI did not intervene to a large extent in the foreign exchange market and let the rupee appreciate in order to check inflation in the Indian economy.

If RBI intervenes in the foreign exchange market to mop up excess US dollars from the market it leads to the increase in money supply in the economy and this causes inflation. Further, appreciation of rupee makes imports cheaper which encourages imports. The increase in imports leads to the rise in aggregate supply of goods which helps in checking inflation.

Changes and Volatility in Foreign Exchange Rate of Rupee:

As a result of the above developments, rupee depreciated a good deal from 1991-92 to 2000-03. From Rs. 21 per US dollar in 1990-91 average annual exchange rate was reduced to Rs. 27 in 1991 -92 (i’. e., about 25 per cent fall in value as a result of devaluation made in July 1991), and it then gradually fell to Rs. 36 in 1997-98 and to Rs. 48 in 2001 -02.

With effect from 2002-03 under pressure of capital inflows, rupee started appreciating and rose to t 47 per US dollar in 2002-03, to Rs. 44.27 in 2005-06. In 2006-07 and 2007-08, there was large inflows of capital through portfolio investment which led to further appreciation of rupee which rose to 39.4 to a dollar on Nov. 12, 2007 which was ten years high level. In the year 2007 alone there was net capital inflows of 17 billion US dollars through F1I which pushed up the value of rupee to a dollar.

Then there was a sub-prime housing loan crisis in the United States which created liquidity crisis in America. To meet the requirements of liquidity at home, FIIs started selling shares in the Indian market and as a result capital outflows occurred during 2008 which gathered momentum in the months of September and October 2008 when rupee depreciated rapidly and its value fell to Rs. 48.53 to a US dollar on Oct. 10, 2008 and to Rs. 49.5 for a US dollar in Nov. 2008 (For some days it fell to Rs. 50 for a US dollar).

The capital outflows by FIIs not only caused depreciation of rupee but also stock market crash in Oct. 2008 and Nov. 2008 and liquidity crunch in the Indian banking system. To ensure credit needs of industries for investment the RBI intervened in the economy by reducing cash reserve ratio (CRR) form 9 per cent to 6.5% and thereby infused liquidity in the economy to the extent of Rs. 1, 40,000 crores and promised to do more if needed.

In the later half of 2011 from September to December 2011, due to uncertainty caused by Eurozone Crisis there has been capital outflows by FIIs from India which caused a sharp depreciation of rupee. Despite some limited intervention by RBI, the value of rupee fell to Rs. 53 to US$ in Mid-December 2011 against Rs. 44 in August 2011, that is Rs. 18 per cent fall in the value of rupee in four months.

This is a matter of serious concern as it has raised the costs of imports of crude oil and other commodities and therefore will not only raise inflation in the economy but will also adversely affect of our balance payments. Besides, the weak rupee will discourage foreign investment in India as investors will suffer losses due to the fall in exchange value of the Indian rupee.

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