The foreign exchange market

Currencies are bought and sold in the foreign exchange market. It is not in one place: it links commercial banks, brokers, authorised dealers and monetary authorities (central banks) around the world.

Demand for foreign exchange (say, dollars) comes from people who:

• buy imports;
• send gifts abroad, or travel abroad;
• buy assets abroad.

When the rupee price of a dollar rises, imports become dearer, so demand for dollars falls: the demand curve slopes down.

Supply of foreign exchange comes from:

• our exports;
• transfers from abroad (remittances);
• foreigners buying our assets, such as Indian shares.

When the price of a dollar rises, our goods become cheaper for foreigners, so exports and the supply of dollars rise.

Under a flexible (floating) exchange rate, the rate is set where demand meets supply, with no central bank intervention. If demand for dollars rises (say, more Indians travel abroad), the rupee price of a dollar rises, for example from ₹75 to ₹80. The rupee has depreciated: it buys fewer dollars. A fall in the rupee price of a dollar is an appreciation of the rupee.