How is the Foreign Currency Exchange Rate Determined?

The determination of foreign currency exchange rates involves various methods and factors. In Nepal, the central bank, Nepal Rastra Bank (NRB), primarily employs two methods:

1. Fixed Exchange Rate: In this system, the government or the central bank maintains the exchange rate of the foreign currency at a stable level. This often applies to the exchange rate between the Indian Rupee and the Nepalese Rupee, which remains fixed. The fixed exchange rate can be pegged to gold or other solid assets.

2. Flexible Exchange Rate: Under this system, the exchange rate of foreign currency is determined by the supply and demand dynamics in the market. The exchange rates fluctuate due to various factors, including the interest rates set by banks and financial institutions, budget deficits, and political stability.

Main Determinants of Foreign Currency Exchange Rates:

1. Interest Rates: Changes in the interest rates of banks and financial institutions affect foreign currency exchange rates. A country with higher interest rates typically sees an increase in the demand for its currency, thereby raising the exchange rate.

2. Budget Deficit: The budget deficit of a government also impacts foreign currency exchange rates. When government expenditure exceeds revenue, it needs foreign currency to cover the deficit, which influences the exchange rate.

3. Political Stability: The political stability of a country plays a significant role in determining foreign currency exchange rates. Political instability can lead to policy changes by different governments, causing fluctuations in exchange rates.

Nepal Rastra Bank publishes daily foreign currency exchange rates, which are then applied by banks and financial institutions. Exchange rates are typically more volatile for currencies such as the US Dollar, Euro, Pound Sterling, Riyal, and Dinar.

Process of Determining Exchange Rates:

- Fixed Rates: Nepal Rastra Bank sets the exchange rates for its own purposes.

- Margins: Banks and financial institutions determine their exchange rates by adding a legal margin to the rates set by the central bank.

Exchange rates can also be determined based on market conditions, primarily influenced by the supply and demand for the currency. A currency with high demand remains strong, while one with low supply becomes weak, leading to fluctuations in exchange rates.

Overall, the exchange rates are influenced by interest rates, budget deficits, and political stability, and are published daily by the central bank for use by consumers and financial institutions for currency exchange.