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Determining the Foreign Exchange Rate

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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 recogniz...

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...porting the hypothesis. The Aloy and Gente Paper (2005) demonstrated that a country’s population structure has an impact on the overall spending, savings, affecting the purchasing power parity and thus the exchange rate.

Other principal factors that cause fluctuations in the exchange rate include the central bank’s intervention, supply of foreign exchange reserves, public debt, trading terms and political stability. Renu Kohli (2002) also attempted to check whether specific factors like structural changes in exchange rate regime, loosening of foreign exchange restrictions and trade liberalization in India had an impact on the real exchange rate. The results showed that with liberalization and development of foreign exchange markets, factors like capital flows, volatility in capital flows and forward premium have become important in determining exchange rates.
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