A flexible exchange rate is a monetary regime where the price of the currency of a nation relative to other currencies is determined by market forces based on supply and demand. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate. In a completely flexible system, the Central Banks do not intervene in the foreign exchange market. Therefore, when the demand for foreign goods and services increases (for example, due to increased international travel by Indians), then the demand curve shifts upward and right to the original demand curve. This increase in demand for foreign goods and services results in a change in the exchange rate. Now, the new equilibrium gets created at “e1” which is higher than the earlier equilibrium “e”. It means that more rupees are to be paid for the foreign currency (dollar). In other words, with increased demand for foreign goods/services, the value of rupees in terms of foreign currency (dollar) has fallen and the value of foreign currency (dollar) in terms of rupees has risen. This situation is called ‘depreciation of domestic currency’ in terms of foreign currency (dollar). Similarly, in a flexible exchange rate regime, when the price of domestic currency in terms of foreign currency (dollar) increases, it is called ‘appreciation of the domestic currency’ (rupees) in terms of foreign currency (dollars). Factors influencing the appreciation and depreciation of the Indian rupee:

• Speculation: When money is being used as an asset and Indians speculate that the dollar is going to increase in value relative to the rupee, they will want to hold dollars to make gains. This expectation would increase the demand for dollars and cause the rupee-dollar exchange rate to increase.
• Inflation: Countries with low inflation (high purchasing power) typically have stronger currencies compared to those with higher inflation rates. This is because inflation decreases the buying capacity of the rupee.
• Interest rates: In the short run, the domestic currency of a country where differential interest rates are higher, appreciates. However, if these rates remain too high for too long, inflation can start to creep up, resulting in a devalued currency.
• Income: In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world normally finds its currency depreciating because its imports grow faster than its exports. Thus, if imports grow faster than exports, the Indian rupee will depreciate and vice-versa.
• Public debt: If the government debt outpaces economic growth, it can drive up inflation, thus depreciating the Indian rupee.
• Current account deficit: Countries that have positive or low current account deficits tend to have stronger currencies than those with high deficits.

Other than these factors, political stability and economic growth are the two factors that attract more foreign investment, which in turn. help lower inflation and drive up the country’s currency exchange rate.