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Almost every currency used by all the countries in the world is called fiat currency. Rupee, Dollar, Euro, Yen and every other currency that you would be able to name are all examples of fiat currencies.
As some of you might already know, earlier our currencies derived their value from the number of gold reserves that our respective countries possessed.
However, the introduction of fiat currencies has made that need redundant. In fact, with fiat currencies, every country is free to print as many currency notes as they want to. (however, it has its constraints)
The question now is then, how does the Indian Rupee, or any fiat currency get its value?
The value of the rupee in relation to the dollar fluctuates on a daily basis. The value of the rupee, like that of any other currency, fluctuates almost daily. Currency fluctuation is a concept that is part of the larger Foreign exchange market. To comprehend the concept and process of a currency's value, one must examine the Foreign Exchange Market.
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What is the Foreign Exchange Market?
The Foreign Exchange Market is simply a global market where fiat currencies are traded. The nature of this market is decentralized. In layman's terms, one fiat currency is exchanged for another at a specific rate. The exchange rate is the rate at which two specific currencies are exchanged.
The exchange rate is the value of one country's currency in relation to the currency of another country. Now if the term fiat currency may have perplexed you then let us understand this term more clearly.
Fiat currency
Fiat money is a type of government-issued currency that is not backed by a physical commodity like gold or silver, but rather by the government that issued it.
The value of fiat money is determined by the relationship between supply and demand, as well as the stability of the issuing government, rather than by the value of the commodity backing it. The majority of modern paper currencies, including the US dollar, the euro, and other major global currencies, are fiat currencies.
The fluctuation of currency
The exchange rate of any country's currency is not constant but rather fluctuates. As a result, the changing value of the rupee is a constant part of our daily news.
Let us understand this with an example The Indian rupee exchange rate in terms of the US dollar is approximately 1 US dollar = 75.87 Indian rupee. This means that 75.87 rupees are required to purchase a dollar from the Foreign Exchange Market using Indian Rupees.
The value determination and Demand & supply
The value of a currency is determined by floating exchange rates in the majority of countries around the world. The value of a currency in this system is determined by the fundamental economic concept of Demand and Supply.
A currency that is in higher demand has a higher value. As different currencies are exchanged in the Exchange market, the demand for each currency in the market determines its value.
Value determination of currency is based on demand & supply and there are many factors to influence the demand & supply as well. In fact, the administration or authority of a country has no or little control over this process of value determination.
Despite this fact, the government or central bank of the local country can intervene when the currency destabilizes or performs poorly.
Overall, the process of demand for a specific currency determines its value.
The value determination and fixed method
There is another system for determining the value of currencies, though it is not as widely used as the one described above. It is known as a pegged exchange system.
The value of a country's currency is fixed with a specific currency in this case. For example, suppose a country decides to fix the value of its currency in relation to the US dollar and sets the value of its currency at 15 cents on the dollar.
The value of that currency, in this case, would still fluctuate, but its ratio with the US dollar will remain the same. Countries like Saudi Arabia, and Qatar use pegged exchange systems.
Movement of currency
The majority of currency exchange takes place at banks. Currencies issued by various countries circulate through banks, and the majority of transactions take place there. A person in Delhi with legal US dollar bills can convert them to Indian rupees at a specific exchange rate at a bank. This bank is a minor player in the vast Foreign Exchange Market.
The central bank of a country (the RBI in India) also keeps a large reserve of foreign currency to deal with any problems that may arise in the Foreign Exchange Market for local currency. As previously stated, when the authorities of a country perceive a bad time for their currency, they intervene.
They accomplish this by either directly adjusting the supply of a specific currency or by changing a few other factors. As previously stated, the value of a currency is determined by supply and demand. Because authority has little control over demand, they impact the value of a currency by making adjustments to the supply of a currency within the market.
The value of the Indian rupee in dollar
Now, you might be curious to know why the US dollar is so strong against the Indian Rupee and several other Asian countries.
The US dollar is in high demand because India imports more goods from the US than it exports. In such a case, demand for the US dollar will rise because more dollars will be paid to the US while purchasing goods from them.
In addition, more dollars will have to be purchased from the Foreign Exchange Market by Indians in order to pay for these goods.
As a result, demand for US dollars relative to the Indian rupee will rise, increasing their value. However, if the Indian Rupee drops substantially in value, the government will intervene.
They will try to minimize the supply of Indian rupees as soon as possible ( to compensate for the low demand). They will buy the Indian rupee on the market using their US dollar reserves.
As it purchases more Indian currency with US dollars, the supply of Indian currency falls while the supply of US currency rises, resulting in an increase in the value of the rupee and a decrease in the value of a dollar. They can also impact supply through other means.
In order to keep one exchange rate at a good value, in the long run, a country must increase demand for its currency. This is just one small example of how the process works; the actual process is much larger and has many levels.
At the end of the day, the demand for a particular currency determines its long-term value. And this demand is influenced by a variety of factors such as a country's fiscal and monetary policies, the amount of trade that occurs in a country, inflation, and people's confidence in a country's political and economic conditions.
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