Sometimes there would be news that the Reserve Bank of India (RBI) has decided to devalue the Rupee. I would interpret “devalue” to mean that the value of Rupee against other currencies has been decreased. However, I also knew that the Rupee changes value everyday and not just those days when there was news from RBI. I would feel curious as to how then the Rupee kept changing its value everyday.
I understood the answer only when I did my MBA. Here is a short summary:
In the good old days, every country would specify its currency in terms of Gold. However, due to the problems associated with this mechanism, especially during times of Gold scarcity – this system was scrapped.
What happens now is that each country chooses what control it wants to have over its currency. It can let the currency float – which means that the market will determine the price based on demand, supply, balance of trade etc. This is the least intrusive method and requires little action from the country’s central bank.
The other is choice the central bank can make is to tie the currency to a fixed set of other currencies. This includes deciding upon a weighted mean formula (based on the currencies in the set) to determine the currency value. All that is needed then, is to find out the values of those currencies on a daily basis and calculate the value of our currency using the formula. This lets the country control its export and import prices to some extent. In such a case, the central bank needs to have the currency partially or fully convertible – and carry out currency exchanges based on the determined formula.
When RBI changes the formula, that is called devaluation – although the rates change daily based on the formula.