Exchange Rate, Meaning, Types, Systems, NEER, REER, PPP

Exchange Rate is an important element in the global economic framework, shaping trade, investment flows, macroeconomic policy, and international competitiveness. It reflects the relative value of one currency in terms of another and plays a decisive role in influencing a country’s economic health, including inflation, exports, imports, and capital flows. Understanding exchange rate systems, currency valuation mechanisms, and factors affecting exchange rates is essential for policymakers, investors, and economists alike. This article provides an in-depth examination of Exchange Rate, its meaning, various types, related concepts such as Nominal Effective Exchange Rate (NEER), Real Effective Exchange Rate (REER), Devaluation, Revaluation, Purchasing Power Parity (PPP), and foreign exchange reserves.

What is the Exchange Rate?

Exchange Rate, also called the rate of exchange, is the price at which one country’s currency can be exchanged for another’s. It represents the relative value of currencies in the international market and indicates how much of one currency is required to buy a unit of another.

For instance, if the US Dollar (USD) is stronger than the Indian Rupee (INR), it implies that the USD can purchase more INR, reflecting higher demand for the USD compared to the Rupee. The exchange rate thus mirrors the demand for a country’s goods, services, and assets internationally.

• A higher demand for a foreign currency relative to the domestic currency results in appreciation of the foreign currency.
• Exchange rates are influenced by trade flows, capital movements, inflation differentials, and interest rate variations.

Exchange Rate Systems Types

Countries adopt different exchange rate systems depending on their economic goals, market openness, and policy priorities. The major systems are:

1. Fixed Exchange Rate System (Pegged System)

In a fixed system, the government or central bank sets the value of its currency relative to a benchmark, which may be gold, silver, or another major currency (e.g., USD or Euro). Characteristics include: 

• Ensures stability in international trade and capital flows.
• Government intervention is necessary to maintain the fixed rate through buying and selling foreign currency.
• Requires large reserves of foreign currency to defend the peg.

Pegging:
When a currency is tied to the value of another currency or commodity (like gold), it is said to be pegged. For example, the Hong Kong Dollar is pegged to the US Dollar.

2. Flexible Exchange Rate System (Floating Rate)

In a floating system, the currency’s value is determined by market forces, the supply and demand of currencies in the foreign exchange market. Characteristics include: 

• No direct government intervention.
• Exchange rates fluctuate continuously based on trade flows, capital movements, and investor sentiment.
• Helps automatically correct imbalances in trade and capital accounts.

3. Managed Floating Rate System (Dirty Floating)

A hybrid between fixed and flexible systems. While the rate is primarily determined by market forces, the central bank intervenes periodically to prevent excessive volatility. Examples include: India uses a managed float, where the Reserve Bank of India (RBI) intervenes to stabilize the Rupee against excessive swings.

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Fixed vs Flexible Exchange Rate Systems 

Fixed and Flexible Exchange Rate Systems have the following differences: 

Devaluation

Devaluation refers to a deliberate reduction in the value of a domestic currency by the government in a fixed exchange rate system.

Impact:

• Makes exports cheaper and more competitive internationally.
• Increases the cost of imports.
• Can improve trade balance if export response is strong.

Revaluation

Revaluation is an increase in the value of domestic currency relative to foreign currencies in a fixed system. Redenomination, which changes the face value of a currency without affecting its exchange rate, is distinct from revaluation.

Devaluation vs Depreciation 

The difference in between devaluation and depreciation is: 

Currency Manipulation

Currency manipulation refers to artificially lowering the domestic currency’s value to gain a trade advantage. Countries can boost exports by making them cheaper internationally, potentially creating trade imbalances.

• The US Treasury monitors currency practices of major trading partners under the Trade Facilitation and Trade Enforcement Act of 2015.

• A country may be labeled a currency manipulator if it meets criteria regarding trade surplus, current account surplus, and foreign currency purchases.

Types of Exchange Rate Markets 

Exchange Rate Markets are of two types. Spot Market and Forward Market.

1. Spot Market

• Deals with immediate purchase and sale of foreign currency, typically settled within 2 days.
• The exchange rate for transactions is the spot exchange rate.

2. Forward Market

• Deals with buying/selling foreign currency at a future date at a pre-agreed rate.
• Useful for hedging risks against exchange rate fluctuations.

Exchange Rates Affecting Factors

Exchange rates are influenced by multiple economic and financial factors:

1. Central Bank Intervention: RBI or other central banks buy/sell foreign currency to stabilize the domestic currency.
2. Inflation Rate: Higher domestic inflation reduces currency demand, causing depreciation.
3. Interest Rate Differentials: High interest rates attract foreign capital, leading to currency appreciation.
4. Trade Balance: Higher exports boost domestic currency; higher imports may depreciate it.
5. Capital Flows: Foreign direct investment (FDI), portfolio investment, and external commercial borrowings affect currency value.
6. Other Factors: Tourism, NRI remittances, political stability, and global economic conditions also influence exchange rates.

Nominal and Real Effective Exchange Rates

Nominal and Real Effective Exchange Rates means the following: 

Nominal Effective Exchange Rate (NEER)

• NEER is the weighted average of bilateral nominal exchange rates of a country against major trading partners.
• Weights are based on trade volume with each country.
• Not adjusted for inflation.

Real Effective Exchange Rate (REER)

• REER adjusts NEER for relative inflation rates, reflecting the real competitiveness of a currency.
• Weights depend on trade balance with each partner country.

Forex Reserves of India

Foreign exchange reserves are assets held by the central bank in foreign currencies, gold, SDRs, and reserve tranches to support currency stability and international obligations. Components of FOREX:

1. Foreign Currency Assets (FCA): USD, Euro, Yen, etc.; includes deposits and government securities.
2. Gold Reserves: To back currency issuance and manage emergencies.
3. Special Drawing Rights (SDRs): IMF-created international reserve asset based on a basket of major currencies.
4. Reserve Tranche: Portion of IMF quota that can be freely accessed by member countries.

Purchasing Power Parity (PPP)

PPP compares currencies using a basket of goods approach. Two currencies are at parity if the same basket of goods costs the same in both countries when adjusted for exchange rates.

Importance of Purchasing Power Parity:

• Useful for comparing real living standards.
• Helps assess whether a currency is overvalued or undervalued.
• Often used to calculate GDP at PPP, reflecting true purchasing power.

Nominal GDP vs Real GDP vs GDP at PPP 

The differences in Nominal, Real and GDP at PPP are: 

Example: A smartphone costing ₹3,000 in India may cost $40 in the US. Using PPP, economists adjust for relative cost of living and exchange rates for meaningful comparisons.

Exchange Rate UPSC

The exchange rate is an important indicator and tool in global finance. It reflects relative currency demand and supply, influences trade, investment, inflation, and economic policy, and serves as a benchmark for international competitiveness.

Understanding the various exchange rate systems are fixed, flexible, and managed float and mechanisms like devaluation, revaluation, NEER, REER, and PPP is important for informed policymaking and strategic economic decision-making.

Furthermore, foreign exchange reserves act as a buffer against external shocks, enabling governments to maintain stability in their currency and meet international obligations.

Mastering the dynamics of exchange rates equips policymakers, investors, and economists with the knowledge to navigate the complexities of international finance effectively, ensuring sustainable economic growth and stability.