This is based on the economies of each country
and relative demand for either of the two currencies. The change is the exchange
rate has got to do with the demand and supply i.e. more supply, less demand
and the lesser will be the value of the currency. Its just the basic principle
So what makes the supply and demand of a
currency change? Well there are many factors regarding this but lets discuss few
of them to get an idea about the whole process.
factor: Expected inflation difference between the two countries. Let us
take an example to understand the inflation rate difference and its effect on the
currency. Suppose India and China are the only two countries in the world. India
currently has inflation of 6% that is expected to rise to 6.5%. China currently
has inflation of 6% that is expected to rise to 9%. Thus Indias expected inflation
is much less than the Chinas expected inflation. Since inflation causes money
to lose value over time, money is more valuable in India (based on time value),
so more people would want to hold Rupees, because the inflation rate in India is
lower than China, your money will be worth more if you convert it into Rupees. I
will not lose as much value as it would if it were in the Chinese currency. So you
see how demand is created for rupees. Everyone would like to buy rupees and sell
their Yuan (Chinese currency). So, the value of Rupees increases.
rate factor: Interest rates also play a key role in exchange rates. High interest
rate economies are attractive to foreign investors whose countries have low interest
rates. Lets say that the US has an interest rate of 5% and India has an interest
rate of 10%, thus the same amount of money is more valuable in India in this example
because you are earning more interest on the same investment. So, effectively the
people in US would be selling their dollars and buying Rupees (i.e. converting their
dollars into Rupees) and putting all that money in Indian banks to earn a much higher
Therefore the more is the demand of Rupees;
the more is the supply or sale of dollar and the value of Rupee increases.
RBI intervention: The valuation of the Indian
currency highly depends on RBI that manages the balance of payments, slight modification
in which can define the over or the under valuation of the Indian currency.
are many factors that arise from the economic structure of Indian economy and affect
the valuation of the Indian currency that in turn affects the economic growth rate
of the economy of a country.