How Currency Exchange Rates are Calculated?

How Currency Exchange Rates are Calculated

Currency exchange rates are determined based on factors like inflation, public debt, political stability, current account deficit, and interest rates. Besides these, market demand and supply is a major factor that affects the currency exchange rates. There exists a direct relationship between demand and supply. As demand rises, producers increase their supply, affecting the price of any product or service in the economy. This means that if Indians want more US Dollars, then the supply-demand relationship will increase the price of the US Dollar at the set price. 

In this blog, we will discuss how exchange rates are calculated, and the types, and factors affecting the currency exchange rates. We will also know about the role of RBI in influencing the exchange rates. 

Also Read: If you are coming back to India after your International travel and left with foreign currency, then check this blog on How to Exchange Foreign Currency to Indian Rupee? 

Calculating Currency Exchange Rates

To calculate the currency exchange rates, we need to understand the two components- base currency and the counter/ quote currency. The base currency is the first currency in a pair, and the quote currency is the second. They are placed together to be compared against one another and to understand how much of the quote currency is required to buy one unit of base currency. 

Example- USD/ INR= 83.12. Here, USD is the base currency and INR is the quote currency. This means to buy 1 USD, INR 83.12 is required. Let’s understand the calculation of currency exchange through two scenarios. 

Scenario #1: When the exchange rate is known. 

Suppose the value of 1 USD is INR 83.12. Now, if Ramesh wants to exchange USD/INR, he would perform the following calculation by dividing the current currency by the exchange rate. 

If he wants to convert 100 USD into INR, he needs to multiply 100 by the exchange rate (83.3). The result would be 8,312 INR. Conversely, if he wants to convert 10,000 INR to USD, he would multiply it by the reciprocal of the exchange rate (1/83.3), and the outcome would be 120.31 USD. 

Scenario #2:  When the exchange rate is unknown.

You can determine it using this currency conversion formula:

Original Currency Amount / New Currency Amount = Exchange Rate

For instance, if you exchange 100 USD for 8312 INR, applying the formula yields an exchange rate of 0.012. This means for 1 INR you’ll get 0.012 USD. 

Types of Currency Exchange Rates

There are two different types of currency exchange rates- fixed exchange rates and floating exchange rates. As the name suggests, a fixed exchange rate is an official exchange rate set by the government of the country and a floating exchange rate keeps on changing, which are also known as flexible exchange rates. Let’s know more about them in detail. 

Flexible exchange rates

These exchange rates are determined by the demand and supply of currencies in a country. In such exchange rates, if a currency demand is less, the exchange rates will be lower and vice versa. The government or the central bank doesn’t intervene to keep the exchange rates fixed or regulated. Instead, the forex market regulates the currency exchange rates. 

Fixed exchange rates

The country’s government sets and maintains the exchange rate which results in an official exchange rate. Fixed exchange rates are set against the international US Dollar. The central bank of the country determines the fixed exchange rate by buying and selling in the forex market in return for the currency it is compared against. 

Also Read: Learn all about making informed financial decisions by checking our blog on Navigating Currency Exchange Risks: What Every Study Abroad Student Should Know

Factors Determining the Calculation of Currency Exchange Rates

Factors like inflation, public debt, political stability, current account deficit, and interest rates affect the currency exchange rates. This is why the exchange rates keep on changing. Let’s understand some important factors- 

Interest Rates

When inflation rises in the country, goods and services become costlier. To tackle the situation, the Reserve Bank of India (RBI) increases the interest rates by increasing the reverse repo rates. In such a situation, the commercial banks are obliged to keep more funds with the RBI and extend fewer funds to the borrowers at higher interest rates. Thus, when the interest rates go up, its currency becomes more valuable. It’s like getting a better deal and investors consider such a scenario favourable to them. Thus, they start spending more in that country, making the exchange rates go up.

Note: The reverse repo rate is the interest rate provided to commercial banks by the Reserve Bank of India when the RBI borrows any amount of money from the commercial banks.

On the flip side, if interest rates drop (as in when intervened by the RBI), the currency becomes less valuable. People might not be as interested in it and investors consider withdrawing their money too, so the exchange rate goes down. 

Money Supply

If a country has a lot of cash floating around (increased money supply), it means that consumers have more money in their hands. This makes them wealthier and leads to more spending resulting in loss in the value of money. Thus, the country’s currency depreciates in the long run affecting the currency exchange rates. In such a scenario, you get less of currency in return when exchanging it.  

Financial Stability

If a country’s economy is strong, more people want to buy its stuff, and more money from other countries flows in. This boosts the local currency’s value.

But if there’s trouble, like economic problems or political issues, investors get worried. They might move their money to more stable places, affecting the exchange rate.

FAQs on How Currency Exchange Rates are Calculated

What is the formula for calculating the exchange rate?

You can determine it using this currency conversion formula:
Original Currency Amount / New Currency Amount = Exchange Rate
For instance, if you exchange 100 USD for 8312 INR, applying the formula yields an exchange rate of 0.012. This means for 1 INR you’ll get 0.012 USD

How the exchange rate is determined?

Currency exchange rates are determined based on factors like inflation, public debt, political stability, current account deficit, and interest rates. Besides these, market demand and supply is a major factor that affects the currency exchange rates. 

What are the factors that determine the calculation of currency exchange rates?

Factors like inflation, interest rates, money supply, and financial stability in the country affect the currency exchange rates. This is why the exchange rates keep on changing. 

What are the types of currency?

There are two different types of currency exchange rates- fixed exchange rates and floating exchange rates. A fixed exchange rate is an official exchange rate set by the government of the country and a floating exchange rate keeps on changing, which are also known as flexible exchange rates. 

How to calculate currency exchange?

Suppose 1 USD = 83.12 INR. Now, if you want to exchange USD/INR, calculate the currency exchange by dividing the current currency by the exchange rate. If you want to convert 100 USD into INR, simply multiply 100 by the exchange rate (83.3). The result would be 8,312 INR. Conversely, if you want to convert 10,000 INR to USD, you need to multiply it by the reciprocal of the exchange rate (1/83.3), and the outcome would be 120.31 USD. 

This was all about how to calculate the currency exchange rates. To know about education loans, the loan application process, the best bank accounts for students, forex and banking experience for global students or international money transfers, reach out to our experts at 1800572126 to help ease your study abroad experience. 

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