Money Supply

An exchange rate depends on the demand and supply of a currency, strong economic fundamentals, good ratings, and a performing equity market boosts the foreign investors’ confidence in the Indian market and attracts foreign capital in India in the form of Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) or Foreign Portfolio Investor (FPI).

Here are a few differences between FDI & FPI:

In general, FDI is seen as a better form of investment in a country.

The huge inflow of foreign funds into the country increases the supply of USD against the Indian rupee and hence USD depreciates, on the contrary, a non performing Indian market compels foreign investors (especially FIIs) to exit the markets and hence the supply of USD against the INR falls and the USD appreciates.

When Indian equity markets are at their peak, they can attract a lot of foreign inflows, and as INR appreciates strongly, whereas the global financial crisis leads to a withdrawal of global liquidity from India, leading the INR to depreciate.

Money Supply:

The money supply is the amount of money available in an economy.

There are three main money stock measures:

M1 = Currency with Public + Demand deposits (DD) + other deposits with RBI

M2 = M1 + Time deposits with short maturity (less than 1 year).

M3 = M2 + Time deposits with a maturity of more than 1 year.

M3 is generally used to measure the money stocked in an economy all over the world.

A change in money supply can have a significant effect on the economic activity of a country, price level, and inflation. Growth in money supply with stable money demand leads to inflation. Thus, it is an important factor affecting exchange rates and the monetary policy of an economy.

The major factors that affect the money supply in an economy are:

• Cash Reserve Ratio (CRR), Repo rate, Reverse Repo, Bank Rates, etc. Any increase (decrease) in the given rates decreases (increases) the money supply.
• FII inflows.

Impact of an Increase in the money supply by RBI:

• Leads to a fall in interest rates.
• Spot exchange rate depreciates as lower rates divert capital flows.
• Forward premium fall led by a decrease in interest rate differentials.

Impact of a Decrease in the money supply by RBI:

• Leads to a fall in interest rates.
• Spot exchange rate appreciates as lower rates divert capital flows.
• Forward premium rise led by an increase in interest rate differentials.