3.1 Determinants of Exchange Rate
Foreign exchange rate is the price of a unit of foreign currency in terms of the domestic currency . In a floating exchange rate mechanism, foreign exchange rate is determined in the same way like the price of any other commodity in a free market economy. Thus, change in the value of the domestic currency relies on factors like foreign exchange reserves, money supply in the economy, the central bank’s policies and differences in the interest yield on dated securities of the concerned economies.
The foreign exchange rate influences purchasing power of income and capital gains obtained from returns, interest rates, inflation as well as foreign direct investment through relative wage and wealth channels. This makes exchange rates an extremely important monetary tool. However, the exchange rate itself is in fact influenced by a number of factors.
3.1.1 Bank Rate
The Reserve bank of India achieves its monetary policy objectives by changing the bank rate. When such a change comes unexpected, the market changes its expectations about the future monetary policy. Therefore an increase in the bank rate, indicating a tight monetary policy, would result in expectations that the bank rate will decrease in the future. This expectation results in a depreciation of currency. However, if the market expects the bank rate to further increase to lower domestic inflation, it would result in anticipation of future appreciation of the currency. This expectation results in appreciation of the currency.
A Report of the Committee on Fuller Capital Account Convertibility accepted that volatility in exchange rate is caused due to flexible exchange rate policy, inflationary pressure and capital inflow. It recognized that interest rate management could be a more efficient in controlling exchange rate volatility. This would require alignment of the domestic interest rates with the international interest rates as well as decrease the misalignment between short-term and long-term interest rates within the Indian money market. The RBI has acknowledged the significance of bank rates in providing stability to the exchange rate in India as the monetary authority prepares for full convertibility on capital account.
3.1.2 Liquidity (Money Supply)
An increase in liquidity within the economy can be seen through growth rates of broad money and foreign exchange reserve. Such an increase in liquidity would result in an anticipation of inflation and increase in the aggregate demand that is likely to cause depreciation of domestic currency. However, an increase in the foreign exchange reserves also indicates an increase in the supply of foreign currency, which could result in appreciation of the domestic currency. Growth rates of broad money and foreign exchange reserves help to further investigate impact on exchange rate. Thus a comparison between the rate of change on money supply in India and that in the US may be determinant of the exchange rate....