- Date : 24/05/2020
- Read: 4 mins
If you’ve ever wondered why the Indian rupee keeps depreciating against the US dollar, here’s what you need to know.
Everything has a price – from the food you eat and the clothes you buy to the house you live in and the car you drive. Anything that provides some form of utility and is desired by a lot of people necessarily has a price. Since you use money to buy these goods and services, you typically may not think of money as a product that has a price.
However, the minute you view the Indian currency in the global scenario of the foreign exchange market, your outlook will change. All currencies , from the Indian rupee to the US dollar, have a price that is more appropriately known as the foreign exchange rate. An exchange rate is basically the price of one country’s currency stated in terms of another country’s currency. For instance, how many Indian rupees it takes to buy one US dollar is the exchange rate between the two currencies.
This exchange rate is constantly fluctuating because most countries follow a flexible exchange rate system where the free market forces of demand and supply determine the exchange rate. Hence, whatever affects the demand and supply of a currency affects its foreign exchange rate too.
Related: History of Indian currency
Here are the most common reasons why the value of a country’s currency can fluctuate:
1. Rate of inflation
Generally, the lower the inflation rate is in a country, the higher is its currency value. This is because its purchasing power increases in relation to other countries where the rate of inflation is high. This means one unit of the low-inflation country’s currency can buy more of a particular product or service than one unit of the high-inflation country’s currency.
2. Difference in interest rates
Interest rates are one way that central banks of countries influence the foreign exchange rate – the interest rates, inflation, and foreign exchange rates are all correlated. When the interest rate of a country increases, it attracts foreign capital since lenders get higher returns relative to other countries where the interest rate is low. This causes the foreign exchange rate to rise as well.
3. Amount of public debt
Public debt is an essential source of government funding and helps finance public sector projects central to a country’s economic growth and development. However, high amounts of public debt can have a negative impact on the foreign exchange rate. Countries with a lot of public debt are not too attractive to foreign investors and this can lead to a higher inflation rate.
4. Current account deficit
When a country spends more on importing goods and services than it earns from exporting the same, there is a deficit in the current account of the balance of trade. In such a case, the country will need to borrow foreign capital to fund this deficit in its foreign payments and earnings. This excess demand for foreign currency, in turn, lowers the domestic currency’s value and negatively impacts the foreign exchange rate.
5. Political and economic stability
If a country is politically unstable and faces a lot of conflict and turmoil, foreign investors will not invest in it because it translates to economic instability. Low amounts of foreign capital will result in lower currency value and frequent currency fluctuations.
Terms of trade, speculation, recession, etc. are some other factors that cause currency fluctuations. In the end, it’s important to remember that all these factors are interconnected; there’s no single factor that determines the currency value in India or any other country. Want to know how India's economy has progressed through the years? Here's a good read for you.