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Recently, there has been much clamour on the depreciating Indian rupee. What is depreciation?
As the name suggests, currency depreciation refers to a fall in value of one currency with respect to another. So, if the Indian rupee (INR) could buy two Sri Lankan rupees today, and could buy only 1.5 tomorrow, INR would have depreciated by 25 per cent.
To put it differently, if one US dollar can buy 45 INRs today, and can buy 60 INRs tomorrow; INR would have depreciated by 33 per cent. The opposite logic holds true for a currency appreciation. But what determines the value of a currency? It is the demand and supply. If more people demand say, US dollar, the value of it goes up relative to the INR, and vice-versa.
Demand for dollar
The demand for US dollar comes from individuals and institutions that require American currency to enter into a transaction. Typically, there are four major heads through which demand for foreign currency come from.
First, importers — who demand foreign currency to pay for the goods they purchase from abroad. Second, individuals who travel abroad carry foreign currency to transact abroad.
Foreign Direct Investments (FDI) — individuals or institutions that invest money abroad to carry on business operations there. Finally, Foreign Institutional Investors (FII) — (individuals or institutions) who buy foreign financial assets such as stocks and bonds. Alternatively, the supply would come from the same four categories located outside of the domestic country. These individuals or institutions would demand the domestic currency to transact in our country.
Extraneous of demand and supply conditions, speculation in currency market could influence the price of the currency.
Exchange rate systems
A note on fixed and flexible exchange rate systems: Theoretically, there are two exchange rate regimes that countries may opt for — however, in practice, many economies fall somewhere between the two ends.
Fixed exchange rate is a system in which the central bank pegs the value of the domestic currency with respect to another, regardless of the demand and supply factors. For instance, the RBI may fix the value of a US dollar to 45 INRs. If demand for the US dollar increases, the central bank would offset the increased demand by flooding the market with excess US dollars from its forex reserves. Thus the parity of 1 US dollar = 45 INRs would be maintained. In this system, since the value of currency remains the same, there is no currency appreciation or depreciation.
Under a flexible exchange rate system, the value of currency is determined by its demand and supply. The central bank does not interfere in the market to offset demand or supply factors. Currently, the RBI follows a policy that leans more towards a flexible system.
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