How does the value of rupee changes against the dollar ?

One important factor is BLACK MONEY i.e. If Politician keep one Million dollar in Swiss Bank at the time when 1 USD = 44 INR. Rate of interest in Swiss bank is very much low. So to keep rate of returns high our Politicians will devaluate INR say they will draft such policies that inflation will increase and Rupee will devaluate say after two years if 1 USD = 88 INR the rate of return for this politician will be 100% in 2 years

This is based on the economies of each country and relative demand for either of the two currencies. The change is the exchange rate has got to do with the demand and supply i.e. more supply, less demand and the lesser will be the value of the currency. Its just the basic principle of economics.

So what makes the supply and demand of a currency change? Well there are many factors regarding this but lets discuss few of them to get an idea about the whole process.

First factor: Expected inflation difference between the two countries. Let us take an example to understand the inflation rate difference and its effect on the currency. Suppose India and China are the only two countries in the world. India currently has inflation of 6% that is expected to rise to 6.5%. China currently has inflation of 6% that is expected to rise to 9%. Thus Indias expected inflation is much less than the Chinas expected inflation. Since inflation causes money to lose value over time, money is more valuable in India (based on time value), so more people would want to hold Rupees, because the inflation rate in India is lower than China, your money will be worth more if you convert it into Rupees. I will not lose as much value as it would if it were in the Chinese currency. So you see how demand is created for rupees. Everyone would like to buy rupees and sell their Yuan (Chinese currency). So, the value of Rupees increases.

Interest rate factor: Interest rates also play a key role in exchange rates. High interest rate economies are attractive to foreign investors whose countries have low interest rates. Lets say that the US has an interest rate of 5% and India has an interest rate of 10%, thus the same amount of money is more valuable in India in this example because you are earning more interest on the same investment. So, effectively the people in US would be selling their dollars and buying Rupees (i.e. converting their dollars into Rupees) and putting all that money in Indian banks to earn a much higher interest rate.

Therefore the more is the demand of Rupees; the more is the supply or sale of dollar and the value of Rupee increases.

RBI intervention: The valuation of the Indian currency highly depends on RBI that manages the balance of payments, slight modification in which can define the over or the under valuation of the Indian currency.

Conclusively, there are many factors that arise from the economic structure of Indian economy and affect the valuation of the Indian currency that in turn affects the economic growth rate of the economy of a country.

Concern about the value of the rupee.  Deteriorating economic conditions, worsening investor sentiment, corruption, uncertain regulatory prospects, etc. can be blamed.and are important when it comes to the overall economic outlook.

But, it we are interested in analyzing why the rupee has fallen, it is actually much simpler than that. Over the last two years, (from April 2010 to April 2012) , the rupee has fallen by around 18% against the dollar. (USDINR has gone from around 44.5 to around 52.5)18% looks like a large fall. If the stock market fell 18% over two years, we would be concerned. If GDP fell by 18% over two years, it would be a crisis. But for the rupee, 18% is actually not a significant fall. In fact, a fall of this magnitude is roughly where the rupee should be. Let’s see why.

Over the last two years, US inflation has average at about 2% per year. In contrast, Indian inflation has averaged at about 10% per year. What this means is that each year, the dollar loses around 2% of its value due to rising prices, and the rupee loses around 10% of its value due to rising prices.Thus, over a 2-year period, the dollar is worth 4% less, and the rupee is worth 20% less. Another way to say this is that the dollar has gained 16% against the rupee over the last two years, simply due to inflation. Now, if the rupee has fallen by 18% against the dollar over the last years, we can see why this is the case.

The fact is that almost all of the rupee’s fall against the dollar can be explained by the difference in inflation rates. If we look the performance of the rupee against the dollar in real terms (i.e. adjusting for inflation), it has actually fallen by only 2%, not 18%.

Now, if we analyze the movements of the dollar and the rupee over short and medium term timeframes, we do see a lot of volatility. Various economic events move the currency in different directions over short-term periods. But once we take a long-term view, the only factor that is relevant to explaining the rupee’s fall is inflation.

As long as India’s Inflation rate is significantly higher than the US inflation rate, we can expect that the rupee will fall against the dollar over time. And this is not necessarily a problem. High inflation is problem that has many negative consequences, and this is what we should be most concerned with