Foreign exchange reserves of India
Consider a person going to London from India for vacation. She needs tourist services in London. For getting services in London, she will have to pay in Pounds. As Pounds is the official currency in London.
For getting pounds, the Indian tourist has to know where to get pounds (GBP) and at what price. This price is known as Exchange Rate. That is the number of Indian rupees needed to buy One GBP.
The Foreign exchange participants are Commercial Banks, Foreign exchange brokers, and other authorized dealers and monetary authorities. The forex market is also called the Foreign exchange market.
A forex market is a market where different currencies are bought and sold. The economy determines the exchange rate of the currencies, out of the trades in different currencies.
Foreign exchange is an institutional framework for the exchange of one countries currency for another countries currencies. This is particularly correct either in the case of a free-float exchange regime such as floating currency or is a managed or hybrid exchange rate system.
Importance of Foreign exchange reserves of India
Foreign exchange rate or Forex rate is the price of one currency in terms of another currency. This links the currencies of different countries and compares different international costs and prices.
For example in the forex market in India, if we have to pay Rs 75 for $1, then the exchange rate is Rs 75 per dollar.
Demand for Foreign exchange
The People in India demand foreign exchange as they want to purchase goods and services from other countries such as the USA, UK, etc. Also, they send gifts to relatives and friends abroad.
Supply of Foreign Exchange
Foreign currency flows into the home country by exports, services by the foreigners such as making the transfer into India or send gifts, or foreigner buy assets such as Home, land in India. A rise in the price of Foreign exchange will reduce the foreigner’s cost.
This increases India’s exports. (Example earlier $1 = 50, now rise in the price of Foreign exchange means, for example, $1 = 80 foreigner can get more services, thereby it increase India’s exports).
Hence the supply of foreign exchange may increase (Based on the Elasticity of demand for exports and imports).
Determination of Exchange Rate
Different countries have different methods of determining their currency exchange rate.
It can be determined by Flexible Exchange Rate, Fixed Exchange Rate, or Managed Floating Exchange Rate.
Flexible Exchange Rate
The exchange rate is determined by the market forces of demand and supply. It is also known as the Floating Exchange Rate.
In a completely flexible system, the Central Banks do not intervene in the foreign exchange market.
As shown in about figure, the exchange rate is determined when the demand curve intersects with the supply curve at point e on the Y-Axis.
At point q on the x-axis determines the quantity of US dollars that have been demanded and supplied on the e-exchange rate. In a completely flexible system, the Central banks do not interfere in the foreign exchange market.
The increase in demand for foreign goods and services results in a change in the exchange rate.
When e0=50, Rs 50 for one dollar.
Then e1=75 which means for Rs 75 = 1$.
It indicates that the value of rupees has fallen in terms of dollars or the value of dollars has risen in terms of rupees. This is called Depreciation of domestic currency/rupees in terms of foreign currency (dollars).
Similarly, in a flexible exchange rate regime, when the price of domestic currency in terms of foreign currency increases, it is called Appreciation of domestic currency. This means the value of rupees has increased, we need to pay fewer rupees in exchange for the dollar.