How are exchange rates determined?
The exchange rate is the value of one currency in terms of another. For example, if a dollar is worth Rs. 45.60
today, the rupee dollar exchange rate is said to be 45.6 to one.

Today, currencies aren’t weighed against each other and valued according to the amount of gold or silver
contained in them, though done long ago to price different currencies. Now, a subtler method values
currencies. Nations which attract more foreign exchange than they lose, see their currencies appreciate; those
that lose more forex than they earn, see their currencies drop in value. The valuation is done by the
marketplace — through the relentless buying and selling of different currencies.

Today, the volume of foreign exchange worldwide tops $1 trillion a day. Nations that run persistent trade
surpluses or have huge capital inflows by way of foreign direct investment or stock market investment see their
currencies appreciate since these inflows raise the stock of foreign currencies against the local one.

On the other hand, trade deficits and capital flight trigger depreciation. In currency markets, the relative
strengths of economies, policies and expectations determine exchange rates.

Why do fundamentals and policies matter in exchange rate determination?
Fundamentals like employee productivity, transportation costs, input prices like energy, communications costs,
taxation levels, quality of government and the fiscal state determine an economy’s efficiency.
These affect export performance and the ability of a country to absorb imports and investments. These
influence the supply of local vs. overseas currencies, and determine exchange rates.

Policy matters a lot. Greater openness exposes nations to overseas trade and investment flows. This can cut
both ways. Countries with good fundamentals do well; however, open economy policies also expose
fundamental weaknesses rapidly. Perhaps the most important job for policymakers in economies trying to open
up is to align domestic policies to global standards. Countries like India, having rickety economic foundations,
are cautious and retain controls on overseas trade and investment.

Why do expectations matter for exchange rates?
Many countries, including India, follow a policy of dirty floats, where the exchange rate fluctuates but is
controlled by the central bank. It often tries to hold currencies to targets or bands, which fundamentals can’t
support. Given these uncertainties, it is profitable to bet on future values of exchange rates, either for
speculative gains or to insure against sudden movements. It’s better for each player to act earlier than later:
hence forex markets move on expectations, and often fully discount the effects of changes in fundamentals
before they actually happen.

A phenomenon known as Sunspots syndromes — when expectations become self fulfilling and trigger actual
changes — is common in forex markets. Eventually fundamentals, which depend on polices, influence interest
rates, prices and eventually exchange rates. But forex markets move much faster than the government
policies. Often movements are caused by simple rumours about policy changes.

Are exchange rate movements bad for the economy?
No. Movements in exchange rates do two important things. One, they tend to correct trade or capital flow
imbalances which would cause tremendous damage if allowed to persist. For example, a sudden depreciation
makes imports more expensive and tends to bring trade deficits down. On the other hand, an appreciation
caused by capital inflows due to high interest rates will choke back exports and some forex earnings, and
eventually arrest the appreciation.

However, large sea-saws in relatively short time are not desirable. One, they make it tough for people to
reckon what a reasonable rate is.