When you visit the U.S. and go shopping, you need dollars to buy things. You can acquire dollars by exchanging your rupees for them. There is a rate at which you can buy the American currency with Indian rupees – for example, you need to give around 71 rupees to buy one dollar.
The exchange rate reflects a country’s economic conditions. It may be controlled by the government for a period of time or be flexible, determined by the market forces of demand and supply. India’s exchange rate was controlled until 1991 after which the government opted for a flexible exchange rate system.
The flexible or floating exchange rate is determined by various factors like inflation, political stability, export-import trade, interest rates etc. These factors determine the demand for a particular currency and its availability around the world. When the demand for a currency rises and supply does not rise correspondingly, then each unit of that currency becomes costlier to buy.
Some governments prefer a controlled exchange rate to create stability in the value of their currencies. In this system, the rate does not fluctuate daily – it may be reset on particular dates known as revaluation dates.
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