Value of Currency
Foreign exchange market (FX, currency market) can be thought of as a global network of banks and financial institutions, selling and buying currencies from each other; an Indian bank buying Dollars by paying in Rupees, a European bank buying Rupees by paying in Dollars etc. Suppose you are planning a trip to Australia and need Aussie Dollars for being able to buy goods and services in Australia. You can go to your local bank like HDFC/ICICI or a currency dealer and can buy Aussie Dollar by paying in Rupees. Instead of an individual, suppose there is an Indian automobile manufacturer who wants to import auto parts manufactured in Japan. The company will have to pay in Japanese Yen to buy these auto parts. So it will buy Yen from a bank or a dealer by paying in Rupee and then pay Yen to the company from which it is buying these parts. Just like you and this company, there are hundreds of thousands of individuals and companies around the world seeking foreign currency for various reasons. They go to their banks and dealers for their needs and these banks and dealers deal with each other to fulfil the needs of such individuals and companies. Hence currency market can be described as an interconnected network of these institutions.
Every day in the newspapers, we keep reading that currency is falling or that the government is doing nothing about currency deprecation etc. The natural question is why is this so important that it needs so much of our attention and why does currency actually fall or rise? First, let’s discuss the second part of our question. Just like other goods and services, price of a currency is also determined by its demand and supply. Suppose today price of USD 1 is Rs 62. Now assume, lot of Indians suddenly start travelling to USA or many Indian companies start buying products from the USA or many Indians start investing in the US in the hope of better opportunities, all these activities will lead to greater demand for US Dollars from India. We have already learnt that as demand for a product/service increases, price of the same also increases. So now USD 1 becomes RS 65 ie we need to pay more, in order to buy USD 1. In this example, USD appreciated with respect to Rupee by 4.84% [(65-62)/62]. In an opposite case when demand for USD decreases, its price will decrease and we will have to pay less. Suppose USD 1 becomes equal to RS 60. In this case, USD depreciated with respect to Rupee by 3.23% [(62-60)/62]. It is important to understand that if demand for USD is increasing from India, it doesn’t mean that it’s increasing from rest of the world as well. So USD might not appreciate against other currencies, as its demand is increasing only against Rupee.
So when a currency appreciates, it means we need to pay more in order to buy 1 unit of the currency. Similarly if currency depreciates, we need to pay less in order to buy 1 unit. As you might have already noticed, price of one currency is given in another currency. In our example, price of USD was given in Rupee. So when one currency in the pair appreciates, another is depreciating simultaneously and vice versa. Let’s say initially USD 1 = INR 60 or 1 INR = 1/60 USD. Now USD depreciates. This means we will have to pay less to buy 1 USD. Suppose it becomes 1USD = 58 INR. So INR 1 becomes USD 1/58. Initially we had to pay USD 1/60 to buy INR 1, but now we will have to pay USD 1/58, which is more. Thus, Rupee appreciated when USD depreciated. Hence, we say that for a currency pair, if one currency is appreciating, the other depreciates and vice versa.
To understand the first part of our question, that why this appreciation and depreciation is so important, read on.