Understanding Why the INR Value Fluctuates Against the USD
Have you wondered why the value of the Indian Rupee (INR) fluctuates against the US Dollar (USD)? This article aims to unwind the mysteries behind these fluctuations, providing insights into the factors that influence the exchange rate.
Factors Influencing the USD/INR Exchange Rate
The answer lies in two fundamental points:
Risk-Free Money Generation
In economics, you cannot generate money without any risk. Consider this scenario:
Let's assume:
1 USD 70 Rs
India's interest rate 6%
US's interest rate 2%
An individual in the US can take a loan of $100 at 2% interest and convert it into Rs 7000. If invested in India, it yields 6% profit (after one year, Rs 7000 becomes Rs 7420). He then converts the Rs 7420 back to USD. With the exchange rate still at 70, Rs 7420 would be worth $106.
This individual can repay the initial loan of $100 plus 2% interest ($102), creating $4 in profit with no risk. Central banks need to prevent such arbitrage, hence the exchange rate needs to adjust. In this case, the 1 USD value should rise to 72.74, to maintain the balance.
Currency Devaluation Methods
Fixed Exchange Rate
Till 1993, the Indian government adopted a fixed exchange rate system. They manually decided the currency's value, often to facilitate foreign loans. However, this method drew criticisms due to the misalignment of currency value with market conditions.
Flexible Exchange Rate
Post-1993, India switched to a flexible exchange rate system, allowing market forces to determine the currency's value. This method relies on various factors:
1. Resources Exported: India exports minerals, pharmaceuticals, and organic chemicals, but not as significantly as the Middle East. Our exports fall short, impacting our currency value.
2. Import-Export Balance: India struggles with exports but relies on imports, particularly essential resources like oil. Promoting the 'Make in India' initiative, such as encouraging local manufacturing, can improve this balance.
3. Inflation Rates: India's inflation rate is higher (around 6%) compared to the USA (around 3.2%). This causes the value of INR to depreciate faster.
4. Stock Market Performance: A weak stock market can deter local and international investors, further impacting currency value.
5. Interest Rates: The Reserve Bank of India (RBI) sets interest rates at which banks provide loans. While higher interest rates can strengthen the currency, increasing them could lead to reduced loan-taking, negatively impacting economic growth.
6. Demand and Supply: Excess printing of notes devalues currency. The release of Rs 2000 and Rs 500 notes saw a controlled reduction in printing volumes to maintain currency value.
Conclusion: Understanding the USD/INR exchange rate involves a detailed analysis of market dynamics, economic policies, and global trends. While India continuously works on improving its economic conditions, fluctuations remain a natural part of global currency markets.
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