Fixed rates and managed floating

Under a fixed exchange rate, the government sets the rate, and the central bank must defend it.

• If the official rate makes foreign currency dearer than the market would (too high a rupee price of a dollar), there is an excess supply of dollars. The RBI must buy the extra dollars, and its reserves grow.
• If the official rate makes foreign currency cheaper than the market would, there is excess demand for dollars. The RBI must sell dollars from its reserves; if it runs out, a black market in dollars appears.

Devaluation: the government raises the fixed rupee price of foreign currency, making the rupee cheaper. Revaluation: it lowers it.

Fixed rates need large and credible reserves, and they invite speculative attacks: speculators bet against a currency they think will be devalued. Such pressures helped end the Bretton Woods system of fixed rates.

Flexible rates correct BoP imbalances automatically, and leave the central bank free to use monetary policy for its own goals.

Most countries today use a mix: managed floating (or 'dirty' floating). The rate floats, but the central bank intervenes, buying and selling currencies, to keep its movements within limits.