OPEN ECONOMY

An economy can be of two types, open and closed. An economy that does not
interact with other economies in the world is called a Closed Economy. There
are no exports, no imports, no capital flows. Open Economy, on the other
hand, is an economy that interacts freely with other economies around the
world. It interacts with other countries in two ways,- (i) by buying and
selling goods and services in world product markets, and (ii) by buying and
selling capital assets in world financial markets.

BALANCE OF PAYMENTS

BOP account of a country of a given year records all the payments made by
foreigners to domestic economic agents and all the payments made by domestic
economic agents to foreigners in the given year. It has two sides, a debit
side and a credit side. All the payments made by foreigners to domestic
economic agents are recorded on the credit side, while all the payments made
by domestic economic agents to foreigners are recorded on the debit side.

The measurement of all international economic transaction between the

residents of a country and foreign residents is called the balance of
payment (BOP).
Essentially, the BOP is a reflection of the supply and demand of a
country’s products, services, financial assets. BOP data is important for
government policymakers and MNEs as it is a gauge of a nation’s
competitiveness or health.
The BOP is an important indicator of pressure on a country’s foreign
exchange rate, and thus, of the potential for a firm trading with or
investing in that country to experience foreign exchange gains or losses.
Changes in the BOP predict the imposition or removal of foreign exchange
controls.
Changes in a country’s BOP may signal the imposition or removal of controls
over payment of dividends and interest, license fees, royalty fees, or other
cash disbursements to foreign firms or investors.
The BOP helps to forecast a country’s market potential, especially in the
short turn . A country experiencing a serious trade deficit is not as likely
to expand imports, at it would be if running a surplus. It may, however
welcome investments that increase its exports.

Domestic economic agents need to be paid in domestic currency. For instance,

if an American tourist comes to India and tries to pay for her travel,
boarding, etc., with dollar, she will fail to do so. She will have to first
go to a foreign exchange dealer (a participant in the foreign exchange
market where currencies of different countries of the world are bought and
sold at market determined prices), a person whose job is to buy and sell
currencies of different countries of the world, and buy rupee with dollar.
In the foreign exchange market, price of every currency is quoted in terms
of every other currency and currency of every country can be bought with the
currency of any other country at the market price of the currency bought in
terms of the currency sold. If the price of dollar at a point of time is 48
rupees, one dollar at that point of time will buy 48 rupees, i.e. the sale
of one dollar for rupee at that point of time will fetch 48 rupees.
International business transactions occur in many different forms over the
course of a year. Domestic economic agents (foreigners) make payments to
foreigners (domestic economic agents) if they
1. purchase produces goods and services from foreigners (domestic
economic agents)
2. Purchase factor services from foreigners (domestic economic agents)
3. make transfer payments, i.e. give gifts, make remittances, etc. to
foreigners (domestic economic agents)
4. purchase financial assets such as shares, debentures, and bank
deposits, as also physical assets such as houses, land, mines and forests
from foreigners (domestic economic agents), which directly adds to the
domestic country’s future receipts from and payments to foreigners. (For
Example, if a domestic economic agent buys bank deposit in a bank located in
Bangladesh, she will receive interest on her deposit in future. So, India’s
future receipt from foreigners will go up. Again, if a resident of Sri Lanka
buys bank deposits of a bank located in India, the bank will pay the
depositor interests in future periods. India’s future payments to
foreigners will therefore go up. Similarly, if an Indian resident buys a
house or land in Pakistan, she can earn rent in future by renting it out.)

So, the BOP account is divided into two segments, viz. current account and
capital account.
The first three kinds of transactions, (i), (ii) and (iii), with the
foreigners, which have no direct bearing on the future receipts from and
payments to foreigners of the domestic economy, are recorded by the Current
Account.
The transactions that have direct bearing on the future receipts from and
payments to foreigners of the domestic economy, i.e. the transactions listed
against (iv), above, are recorded in the Capital Account.

As discussed earlier, the sale of produced goods and services to foreigners

and purchase of produced goods and services from foreigners are referred to
as export and import of produced goods and services, respectively.
Similarly, sale of factor services to foreigners and purchase of factor
services from foreigners are referred to as export and import of factor
services, respectively.
Suppose that an Indian resident holds shares of a company located in USA.
Accordingly, she gets dividend from the firm. Firms use the proceeds from
the sale of the shares to purchase produced means of production or capital
and pay dividend for the productive services provided by them. The dividend
paid to the Indian resident by the US-based firm is the price of the service
rendered by the capital purchased with the proceeds from the sale of the
shares to the Indian. This dividend is therefore a payment for the purchase
of factor services and is recorded on the credit side of the current
account.
(If the dividend is paid in dollar, the Indian, not being able to buy
anything using dollar in India, will sell the dollar in the foreign exchange
market to buy the rupee.)
Similarly, if an Indian holds his savings in a deposit with a bank located
in USA, the interest the bank pays him is a factor payment for the service
provided by the bank deposit, which is a part of the bank’s capital, i.e.,
when a bank takes deposits and lends them out, the excess of the interest
that it receives from its loans over the interest that it pays to its
depositors constitutes its profit or income.
Thus, the main productive asset that a bank uses to earn its income or to
produce the service it renders, namely, securing savings from the savers and
making them available to deserving borrowers, is the deposits. Hence,
deposits constitute the main component of a bank’s capital stock.
Again, if an Indian resident owns a house or a piece of land in Nepal and
rents it out, the rent she receives is a payment for the sale of the service
rendered by the house or the piece of land. The service is a factor service
and payment for the purchase of this factor service is recorded on the
credit side of the BOP account.
Transfer payments to foreigners mean giving gifts to foreigners. Suppose, an
Indian who is residing in USA while working there, sends a part of her
income to her parents who reside in India. The remittance, treated as a
transfer payment made by a foreigner to Indians, is recorded as a credit
item in the current account of India’s BOP account.
Similarly, if a US citizen works in India and sends a part of her income to
her parents residing in USA, the remittance will be treated as a transfer
payment made by an Indian resident to foreigners and will be recorded on the
debit side of the BOP account.
[ Note :- Since Indian residents cannot use dollar for purchasing goods and
services in India, either the foreigners making transfer payments to the
Indians will have to first buy rupee by selling dollar and then make the
payment or the Indian residents receiving these remittances will have to
sell the dollar received to buy rupee. ]

Hence, the components of current account are,-

1. Net exports of goods and services (NX)
=> Exports of goods and services [ + ]
=> Imports of goods and services [ - ]
2. Net income from abroad (NFP)
=> Income receipts from abroad [ + ]
=> Income payments to residents of other countries [ - ]
3. Net unilateral transfers [ + ]

Adding all the credit items and subtracting all the debit items in the
current account yields a number called the current account balance.
If the current account balance is positive, i.e. if the sum of the items on
the credit side of the current account exceeds the sum of the items on its
debit side, the excess of the former over the latter is referred to as
current account surplus. In the opposite case, when current account balance
is negetive, the excess of the sum of the items on the debit side over the
sum of the items on the credit side is referred to as current account
deficit.

Purchases and sales of physical and financial assets by domestic economic

agents to and from foreigners are recorded in the capital account of the BOP
account of a country. The sales of these assets, which are alternatively
referred to as import of capital, are recorded on the credit side, while the
purchases of these assets, alternatively referred to as export of capital,
are recorded on the debit side.
The sales of financial assets (e.g bank deposits, shares, debentures) to
foreigners amount to taking loans from foreigners. Similarly, the purchases
of financial assets from foreigners amount to giving loans to foreigners.
Its important to note that, to purchase physical and financial assets from
foreigners, domestic economic agents have to first buy foreign currencies by
selling domestic currency and vice versa.
Hence, the basic components of capital account are,-
1. Increase in foreign holding of domestic assets [ + ]
2. Increase in domestic holding of foreign assets [ - ]

But, to be more precise, the different components of capital account

include,-
1. Foreign investment
=> Foreign Direct Investment consisting of foreigners building
production facilities in India or buying controlling stakes in Indian
companies. [ + ]
=> Foreign Portfolio Investment consisting of foreigners buying and
selling in Indian shares and securities market without gaining control
over any Indian company. [ - ]
2. Loans consisting of external assistance, external commercial
borrowing, and short term loans to India. The last item refers to
suppliers’ credit.
=> Inflow of loans through ECB [ + ]
=> Repayment of loans taken through ECB [ - ]
=> Inflow of supplier’s credit [ + ]
=> Buyer’s credit provided by Indian importers [ - ]
3. Banking Capital mainly of Indian commercial banks’ lending to
foreigners, investing in foreign assets and receiving deposits from
foreigners.
=> NRIs or foreigners deposit their savings in Indian commercial banks
[ + ]
=> Indian commercial banks purchase foreign financial assets [ - ]
4. Rupee Debt Service (India has outstanding loans with Russia, which
India could service with rupee. Rupee debt service refers to the debt
service payments by India on this loan.)
[ - ]
5. Other Capital
=> Leads in exports [ + ]
=> Lags in exports [ - ]

Foreign investment has two components—foreign direct investment (FDI) and

foreign portfolio investment. The former consists of foreigners setting up
production facilities or expanding existing production facilities in India
or buying Indian companies or purchasing so many shares of an Indian company
that they are gaining control over the company. When foreigners make foreign
direct investment, it is recorded as a credit item. When they do just the
opposite, i.e. when they sell off Indian companies they bought earlier or
sell off their controlling stakes of Indian corporations, it is recorded as
a debit item.
External commercial borrowing (ECB) refers to borrowing by Indian companies
from international credit market. The distinction between ECB and foreign
investment is that the latter refers to real or financial investment by
foreigners in Indian money and capital markets, while the former consists in
Indian companies taking loans from foreign money and capital markets. Inflow
of loans through ECB is recorded on the credit side and repayment of loans
taken through ECB is recorded on the debit side.
‘Short term to India’ refers to short term credit given by foreign
suppliers to Indian importers and buyers’ credit provided by Indian
importers who make advance payments for imports to foreigners. (For example,
suppose an Indian company buys intermediate inputs from a foreign company on
a three-month credit, i.e. the foreign company allows the Indian company to
pay for the intermediate inputs bought three months later. This is a three-
month supplier credit given by the foreign company to the Indian company. )
Inflow of supplier’s credit is a credit item, while buyer’s credit
provided by Indian importers to foreigners is recorded as a debit item.
‘Banking capital’ refers to inflow of NRI and foreigners’ deposits into
Indian commercial banks and acquisition of foreign assets by Indian
commercial banks. When NRIs or foreigners deposit their savings in Indian
commercial banks, these inflows are recorded as credit items. When Indian
commercial banks purchase foreign financial assets, the outflows are
recorded as debit items.
India took loans from the erstwhile Soviet Union and these loans, unlike
other foreign loans, could be serviced with rupee. ‘Rupee debt service’
refers to debt service payments made by India on these loans. These payments
are obviously recorded on the debit side.
Other capital consists of leads and lags in export. Advance payments by
foreigners for export, referred to as leads in export, are loans (short
term) or buyers credit and are recorded on the credit side. Similarly,
delayed payments by foreigners for imports, referred to as lags in export,
are suppliers credit given to foreigners and are therefore recorded on the
debit side.

THE RELATIONSHIP BETWEEN THE CURRENT ACCOUNT AND THE CAPITAL AND FINANCIAL
ACCOUNT - BALANCE OF PAYMENT ACCOUNTS

The sum total of the debit items and that of the credit items, taking the
current account and the capital account together in the BOP account, has a
specific relation, i.e. the two sides are always equal. But how ?
Domestic economic agents are the only source of domestic currency to the
foreigners, while foreigners are the only source of foreign exchange to the
domestic economic agents. Receipts from foreigners, mean sale of foreign
exchange for domestic currency, while payments to foreigners mean purchase
of foreign currency with domestic currency. If the total of payments to
foreigners in a given period exceeds the total of receipts from foreigners,
it means that domestic economic agents in the given period have purchased
more foreign exchange with domestic currency than what the foreigners have
sold for domestic currency. Clearly, that is impossible since foreigners are
the only source of foreign exchange to the domestic economic agents. For
similar reasons, total payments to foreigners cannot be less than the total
of receipts from foreigners either. This means that, if there is a surplus
on the current account, there is an exactly equal amount of deficit on the
capital account and vice versa.
Balance of Payment Accounts is basically the sum of current and capital
accounts, which means the difference between the receipts from and payment
to foreigners by residents of a country. Now, BOP always balances, which
implies that credit and debit side must equal each other and so is for the
case of payments and receipts. This can only only happen when BOP is in
equilibrium, that is when,-
BOP = 0
Again, BOP = CA + KA
= R - P
Where, CA = current accounts
KA = capital accounts
R = Receipts
P = Payments
So, as , in each period the current account balance and the capital and
financial account balance must sum to zero, in order that BOP balances,
hence,-
CA + KA = 0
So, when BOP = 0, balance of payment is in equilibrium. When BOP>0, there is
favourable balance of payments; When BOP<0, there is unfavourable or adverse
balance of payments. When there is a surplus or a deficit in balance of
payments there is said to be disequilibrium in balance of payments. Thus
disequilibrium refers to imbalance in balance of payments.

In reality BOP may not balance, due to errors and omissions. Errors may be
due to statistical discrepancies (differences) and omissions may be due to
certain transactions may not get recorded. The amount that would have to be
added to the sum of the current account and the capital and financial
account balances for this sum to reach its theoretical value of zero is
called the statistical discrepancy.

Well, at this point, the central bank of every country, which carries a
stock of foreign exchange, plays an important role here. Exchange rate of a
foreign currency means the price of the foreign currency in terms of the
domestic currency. Every foreign currency has an exchange rate. The central
bank often buys foreign exchange with domestic currency or sells foreign
exchange for domestic currency in the foreign exchange market to keep the
exchange rates stable.
Suppose that the Reserve Bank of India (RBI) wants to keep the exchange rate
of dollar at 40/-. If at this exchange rate there is excess demand for
dollar, i.e. if at this exchange rate domestic economic agents want to buy
more dollar with rupee than what the US residents want to sell for rupee,
exchange rate will rise. The RBI can prevent the rise of the exchange rate
of dollar by selling dollar for rupee from its foreign exchange reserve.
Similarly, if there is excess supply of dollar, i.e. if the US residents
want to sell more dollar for rupee than what the Indian residents want to
buy, the exchange rate tends to fall. The RBI can stop this decline by
buying the excess supply of dollar with rupee and adding it to its foreign
exchange reserve.

Hence, when the central bank intervenes in the foreign exchange market, the
total of the items on the debit side in the current and capital account
taken together may exceed (fall short of) that on the credit side, i.e.
there may be a BOP deficit (surplus) taking the current and capital account
together. But in that case, the foreign exchange reserve of the central bank
will fall (rise) exactly by an equal amount.
In a country where the central bank intervenes in the foreign exchange
market, there is a third segment in the BOP account. This is referred to as
the official settlement account. In this account a fall in the central
bank’s foreign exchange reserve is recorded on the credit side, while
addition to the central bank’s foreign exchange reserve is recorded on the
debit side. Thus, if there is an overall deficit (surplus) on the current
and capital account taken together, there should be an equal amount of
surplus (deficit) on the official settlement account.
So, we may say that,-
CA + KA + OS = BOP
And when BOP balances that is its in equilibrium, then,-
BOP = 0
=> CA + KA + OS = 0
Recording of receipts from and payments to foreigners may involve errors and
omissions. Thus, if there occurs any discrepancy between change in RBI’s
foreign exchange reserve and the overall balance, taking the current and the
capital account together, the discrepancy is recorded as “errors and
omissions” so that the sum of the items on the credit side and that on the
debit side become equal, when all the three segments are considered
together.

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

I. THE FLOW OF GOODS: EXPORTS, IMPORTS, AND NET EXPORTS

Exports are domestically produced goods and services that are sold abroad,
and imports are foreign-produced goods and services that are sold
domestically. Net Exports (NX) is the value of a nation’s exports minus the
value of its imports, i.e.,-
Net exports = Value of country’s exports – Value of country’s imports
Because net exports tell us whether a country is, in total, a seller or a
buyer in world markets for goods and services, net exports are also called
the trade balance.
If net exports are positive ( NX > 0 ), exports are greater than imports ( X
> M ), indicating that the country sells more goods and services abroad than
it buys from other countries. In this case, the country is said to run a
trade surplus.
If net exports are negative ( NX < 0 ), exports are less than imports
( X < M ), indicating that the country sells fewer goods and services abroad
than it buys from other countries. In this case, the country is said to run
a trade deficit.
If net exports are zero ( NX = 0 ), its exports and imports are exactly
equal ( X = M ), and the country is said to have balanced trade.
Factors that affect Net Exports are :
a. The tastes of consumers for domestic and foreign goods.
b. The prices of goods at home and abroad
c. The exchange rates at which people can use domestic currency to buy
foreign currencies
d. The incomes of consumers at home and abroad
e. The cost of transporting goods from country to country
f. Government policies toward international trade

II. THE FLOW OF FINANCIAL RESOURCES: NET CAPITAL OUTFLOW

During an international transaction/trade, the first transaction would

represent a flow of goods, whereas the second would represent a flow of
capital. In this context, its important to know about Net Capital Outflow.
The term net capital outflow refers to the difference between the purchase
of foreign assets by domestic residents and the purchase of domestic assets
by foreigners, i.e.,-
Net capital outflow = Purchase of foreign assets by domestic residents
- Purchase of domestic assets by foreigners.
Suppose, an Indian resident buys a stock in Toyota Corporation. This raises
the purchase of foreign assets by domestic residents, and hence, increases
the net capital outflow of India. But, on the other hand, suppose, when a
Japanese resident buys a bond issued by the Indian government, the its
basically increasing the purchase of domestic assets by foreigners, thus
reducing India’s net capital outflow.
The flow of capital between the Indian economy and the rest of the world
takes two forms. Suppose, Arsalan opens up a fast-food outlet in Bangladesh,
that is an example of foreign direct investment, where the Indian owner
actively manages the investment. On the other hand, suppose, an Indian buys
stock in a Bangladeshi corporation, that is an example of foreign portfolio
investment, where the Indian owner, being a stockholder, has a more passive
role. In both cases, Indian residents are buying assets located in another
country, so both purchases increase Indian net capital outflow.
The net capital outflow (sometimes called net foreign investment) can be
either positive or negative.
When it is positive, domestic residents are buying more foreign assets than
foreigners are buying domestic assets. Capital is said to be flowing out of
the country.
When the net capital outflow is negative, domestic residents are buying less
foreign assets than foreigners are buying domestic assets. Capital is said
to be flowing into the country. That is, when net capital outflow is
negative, a country is experiencing a capital inflow.
Some of the more important variables that influence net capital outflow are:
• The real interest rates paid on foreign assets
• The real interest rates paid on domestic assets
• The perceived economic and political risks of holding assets abroad
• The government policies that affect foreign ownership of domestic assets
For example, consider Indian investors deciding whether to buy Chinese
government bonds or Indian government bonds. To make this decision, U.S.
investors compare the real interest rates offered on the two bonds. The
higher a bond’s real interest rate, the more attractive it is. While making
this comparison, however, Indian investors must also take into account the
risk that one of these governments might default on its debt (that is, not
pay interest or principal when it is due), as well as any restrictions that
the Chinese government has imposed, or might impose in the future, on
foreign investors in China.

III. THE EQUALITY OF NET EXPORTS AND NET CAPITAL OUTFLOW

Net exports and net capital outflow each measure a type of imbalance in a
world market. Net exports measure the imbalance between a country’s exports
and imports in world markets for goods and services. Net capital outflow
measures the imbalance between the amount of foreign assets bought by
domestic residents and the amount of domestic assets bought by foreigners in
world financial markets.
For an economy, net exports must be equal to net capital outflow.
NCO = NX
This equation holds because every transaction that affects one side of this
equation affects the other side by exactly the same amount. This equation is
an identity— an equation that must hold because of the way the variables in
the equation are defined and measured.
To see why this accounting identity is true, let’s consider an example. You
are a computer programmer who sells some software to a Japanese consumer for
10,000 yen. The sale is an export for the United States so net exports
increases. There are several things you could do with the 10,000 yen. You
could hold the yen (which is a Japanese asset) or use it to purchase another
Japanese asset. Either way, net capital outflow rises. Alternatively, you
could use the yen to purchase a Japanese good. Thus, imports will rise so
the net effect on net exports will be zero. One final possibility is that
you could exchange the yen for dollars at a bank. This does not change the
situation though, because the bank then must use the yen for something.
This example can be generalized to the economy as a whole,-
a. When a nation is running a trade surplus (NX > 0), it must be using
the foreign currency to purchase foreign assets. Thus, capital is flowing
out of the country (NCO > 0).
b. When a nation is running a trade deficit (NX < 0), it must be financing
the net purchase of these goods by selling assets abroad. Thus, capital is
flowing into the country (NCO < 0).
Every international transaction involves exchange. When a seller country
transfers a good or service to a buyer country, the buyer country gives up
some asset to pay for the good or service. Thus, the net value of the goods
and services sold by a country (net exports) must equal the net value of the
assets acquired (net capital outflow).

IV. SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE INTERNATIONAL FLOWS

Actual economies are open economies—that is, they interact with other
economies around the world. So, here, GDP constitutes of all the four
components :
Y = C + G + I + NX
From here, we can write Net Exports as :
NX = Y - C - G - I
Now we know that, National Savings (S) is defined as the total income in the
economy that remains after paying for consumption and government purchases
i.e. (Y – C – G ). So, we can substitute S in the previous equation :
NX = S - I
Now, this relation is somehow related to capital inflows and outflows.
Capital Inflows mean that foreigners are taking capital into our country ti
buy assets in our country, while on the other hand, Capital Outflows mean
that residents of our country are taking capital out of the country and
buying foreign assets in other countries. Now according to the last
equation, we save some and we spend some of that savings in investment. So
the rest of the savings that is the difference between S and I must go out
of the country. If it were spent inside the country, then it would’ve been
a part of I. So this difference is called Net Capital Outflow (NCO). So,
NX = NCO
Now, suppose NX are positive. That means more foreigners are buying our
goods and we are buying their goods. Now they pay for these goods by selling
their foreign assets to people of our country. Hence people of our country
buy foreign assets so that foreigners can buy our goods.
Now, we can also write
S - NX = I
Now, it can also be said that nation’s saving must equal its domestic
investment plus its net capital outflow, i.e.,-
S = I + NX
or, S = I + NCO
So, in other words, when Indian citizens save a rupee of their income for
the future, that rupee can be used to finance accumulation of domestic
capital or it can be used to finance the purchase of capital abroad.
Hence, the main point is that, saving, investment, and international capital
flows are inextricably linked. When a nation’s saving exceeds its domestic
investment, its net capital outflow is positive, indicating that the nation
is using some of its saving to buy assets abroad. When a nation’s domestic
investment exceeds its saving, its net capital outflow is negative,
indicating that foreigners are financing some of this investment by
purchasing domestic assets.
[ Now, if NX = NCO, then negetive of NX i.e. (-NX) would be Net Capital
Inflows. So, we can say :
S + Net Capital Inflows = I
This means that whatever investment happens in our country, its either
coming from the savings or the Net Capital Inflows that is the capital
brought by foreigners in our country. ]

So, from the international flow of goods and capital, its clear that there
are three possible outcomes for an open economy, viz., a country with a
trade deficit, a country with balanced trade, or a country with a trade
surplus.

By definition,-
1. A trade surplus means that the value of exports exceeds the value of
imports. Because net exports are exports minus imports, net exports NX are
greater than zero. As a result, income Y = C + I + G + NX must be greater
than domestic spending C + I + G. But if income Y is more than spending C +
I + G, then saving S = Y – C – G must be more than investment I. Because
the country is saving more than it is investing, it must be sending some of
its saving abroad. That is, the net capital outflow must be greater than
zero.
2. A trade deficit means that the value of exports is less than the
value of imports. Because net exports are exports minus imports, net exports
NX are negative. Thus, income Y = C + I + G + NX must be less than domestic
spending C + I + G. But if income Y is less than spending C + I + G, then
saving S = Y – C – G must be less than investment I. Because the country
is investing more than it is saving, it must be financing some domestic
investment by selling assets abroad. That is, the net capital outflow must
be negative.
3. A balanced trade means that the value of exports is equal to the
value of imports. Because net exports are exports minus imports, net exports
NX are 0. Thus, income Y = C + I + G + 0 must be equal to domestic spending
C + I + G. But if income Y is equal to spending C + I + G, then saving S = Y
– C – G must be equal to investment I. Because the country is investing
same as it is saving, it doesn’t need to finance any domestic investment by
selling assets abroad. That is, the net capital outflow is 0.

EXCHANGE RATE

International transactions are influenced by international prices. The

exchange rate between two countries is the price at which residents of those
countries trade with each other. It is basically the value of one currency
expressed in terms of another currency. Suppose transactions with other
countries require that US dollars be exchanged for foreign currencies-
Indian Rupee, Japanese Yen, etc. The exchange rate is the price at which
these exchanges of dollars for foreign currencies take place. The dollar
exchange rate measures the price of dollars in terms of foreign currencies.
The two most important international prices: the nominal and real exchange
rates.

Nominal Exchange Rates ( e )

The nominal exchange rate is the rate at which a person can trade the
currency of one country for the currency of another. For example, if you go
to a bank, you might see a posted exchange rate of 81 rupees per dollar. An
exchange rate can always be expressed in two ways. If the exchange rate is
81 rupees per dollar, it is also 1/81 (= 0.0123) dollar per rupee.
The dollar–rupee exchange rate isn’t constant. The dollar might trade for
81/- one day, but the next day it might rise in value to 92/- or fall in
value to 75/-. Such changes in the exchange rate are normal under a
flexible-exchange-rate system, the type of system in which many of the
world’s major currencies (including the dollar and the yen) are currently
traded. In a flexible-exchange-rate system, or floating-exchange-rate
system, exchange rates are not officially fixed but are determined by
conditions of supply and demand in the foreign exchange market. Under a
flexible-exchange-rate system, exchange rates move continuously and respond
quickly to any economic or political news that might influence the supplies
and demands for various currencies.
Although no worldwide system of fixed exchange rates currently exists, fixed
exchange rates haven’t disappeared entirely. Many individual countries,
especially smaller ones, attempt to fix their exchange rates against a major
currency.
When Nominal Exchange Rate increases, it means that a dollar is now equal to
more rupees, i.e. it takes more rupees to purchase a dollar now, hence
making a rupee less valuable with respect to dollar, thus causing
Depreciation of the Currency.
Now, conversely, when Nominal Exchange Rate decreases, it means that a
dollar is now equal to less rupees, i.e. it takes less rupees to purchase a
dollar now, hence making a rupee more valuable with respect to dollar, thus
causing Appreciation of the Currency.
Depreciation and appreciation happens with regard to perfectly floating or
flexible exchange rates.
When e remains fixed and government by policy increases e, its called
Devaluation, which is a policy tool. But depreciation isn’t. Depreciation
basically means, following any change in the international market, our
exchange rate changes.