Exchange rate can be defined as the value of one currency in terms of another. India follows floating exchange rate system for the determination of the exchange rate. Floating exchange rate system can be defined as a system where the exchange rate between currencies are not fixed but they keep fluctuating, as they are determined by the demand and supply for the domestic currency in the international market. Floating exchange rate system is of two types –
1. Free Float – Under this the exchange rate of a country is determined by the market and there is no intervention either by the government or the central bank of the country. It is determined by the interaction of the demand and supply for the currency. Under this system there is a risk of the currency either appreciating or deprecating suddenly resulting in currency coming in to pressure and becoming more volatile. It is also called clean float.
2. Managed Float – In order to reduce the volatility in currency countries follow managed float, under this system central banks of the country tend to intervene from time to time in order to smoothen the fluctuations in the exchange rate in the currency market.