How is foreign exchange rate determined?

When you visit the U.S. and go shopping, you need dollars to buy things. You can acquire dollars by exchanging your rupees for them. There is a rate at which you can buy the American currency with Indian rupees – for example, you need to give around 71 rupees to buy one dollar.

The exchange rate reflects a country’s economic conditions. It may be controlled by the government for a period of time or be flexible, determined by the market forces of demand and supply. India’s exchange rate was controlled until 1991 after which the government opted for a flexible exchange rate system.

The flexible or floating exchange rate is determined by various factors like inflation, political stability, export-import trade, interest rates etc. These factors determine the demand for a particular currency and its availability around the world. When the demand for a currency rises and supply does not rise correspondingly, then each unit of that currency becomes costlier to buy.

Some governments prefer a controlled exchange rate to create stability in the value of their currencies. In this system, the rate does not fluctuate daily – it may be reset on particular dates known as revaluation dates.


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