EXCHANGE RATES AND MACRO ECONOMY

Economic transactions take place among the countries following open economy system.
India is also fully committed to globalization since 1991. Since India is a member of World
Trade Organization, practically there is no restriction either on exports from or imports into
the country unless the products are related to defense, nuclear or environment. Following
are the two factors which influence trade relations among countries namely,[i] Relative
Prices and [ii] Economic situation among the trading partners.

In a normal situation people go for imported products only if price is comparatively lower
than that of domestic product. Otherwise, tendency is to patronize domestic products.
Similarly, economic situation is a crucial factor in deciding trade relations. Economically
prosperous countries are in a better to position to import foreign goods. A country with
dismal economic performance may not be in a position to import goods even if prices are
lower than the domestic products.

Rate of Exchange

Rate of exchange is value of one currency in terms of another currency. Fixed rate of
exchange rate is the one determined by the government through administrative decision.
Floating or flexible exchange rates are determined through market forces i.e. demand for
and supply of foreign currency.

Export earnings, flow of foreign investment, remittances from non-resident citizens,

repatriation by local business units operating outside, foreign tourists visiting the country,
foreign loans etc. result in inflow of foreign currency. On the other, import payments,
foreign travel, remittances by expatriates based here, repatriation of profit earned by
foreign companies, servicing of foreign loans etc. lead to demand for foreign currency.
Depending on outflow of foreign currency due to demand and inflow of foreign currency
due to supply, rate of exchange fluctuates.

Let us examine how fluctuation in rates of exchange impact trade relations which in turn,
GDP.

1. Impact of Appreciation of Local Currency

Take the case of following changes in rate of exchange:

On mid-November, 2016………………………. $1=Rs. 69.

On mid-November, 2017……………………… $1=Rs.65 [Note: We have taken round figures].

During the above period, the local currency i.e. rupee got strengthened or appreciated.
Exports: Let us examine its impact on trade. Suppose, handmade Indian carpet priced at Rs.
1ooooo is in demand in the US market. US consumer was required to pay $ 1449 in
November 2016 in view of the prevailing rate exchange between the two currencies i.e.
$1=Rs. 69 at that point of time. Since Indian currency got appreciated against dollar at
$1=Rs. 65, the US consumer is required to pay $ 1538 for the same carpet. Despite price of
Indian carpet remaining constant at Rs. 100000, the US consumer was required to pay
higher price in November 2017 -in terms of their currency because of appreciation of the
Indian currency against dollar. Demand for Indian products was bound to fall with rise in
price in dollar terms which meant fall in exports from India and consequently negative
impact on GDP

Import: Suppose, US made leather bag priced at $ 1000 was in demand in Indian market. In
terms of the rate of exchange in November 2017, Indian consumer was required to pay Rs.
65000 whereas the same product was sold in Indian market for Rs. 69000 in November
2016. Thus, US product had become cheaper in terms of rupee despite its original price
remaining the same at $ 1000 -because of appreciation of rupee. Fall in price in terms of
rupee increased demand from Indian consumers i.e. increase in imports from US.

2. Impact of Depreciation of Currency

Look at the fluctuation in rates of exchange from $ 1= Rs.64 at the end of October 2017 to

$ 1= Rs. 76 in December 2021. That is the case of Indian currency getting depreciated
against US currency during the last four years.

As a result, American importer is required to pay only $ 1316 in December, 2021 as against
the price of $1563 four years back for the Indian carpet priced at Rs. 100000 in India. Indian
carpet has become cheaper to US importer in terms of dollar though price of carpet
remained constant at Rs.100000 due to depreciation of Indian currency as against US dollar.
Cheaper Indian products results in rise in demand. In other words, Indian exports are
expected to rise as a result of depreciation of local currency.

On the other, Indian consumer is required to pay Rs. 76000 in December, 2021 as against Rs.
64000 in October 2017 for the same US laptop priced at $ 1000. With price of laptop going
up in terms of Indian currency demand is expected to fall in Indian market-leading to fall in
imports from US.

Thus, it may be concluded that depreciation of local currency pushes exports up while
imports are expected to fall.

Depreciation resulting in rise in exports would help in expanding real GDP while
appreciation contracts real GDP with fall in exports.