EXCHANGE RATE SYSTEM:

It is interesting to look at a case study of a country like India for several reasons: first it is a small country in terms of imports and exports as a proportion of world imports and exports. Secondly, it is a developing nation that had an experience of being colonised. Thirdly, the government intervened heavily in the foreign exchange market, and over the lat 15 years or so, there has been liberalisation, whereby the government has liberalised the exchange rate policy. Finally, and related to the above point is the fact that India has changed its exchange rate regime from an earlier fixed one to a new one. Also the exchange control system has changed.

Let us now study the exchange rate mechanism and system operative in India and explore how it has undergone changes over the years. Before the IMF came into being, the rupee was linked to the pound sterling. In India, there was a sterling exchange standard till 1947. When India became a member of the IMF, the rupee-pound sterling link was severed, and the rupee's par value came to be expressed in gold. Since in the Bretton Woods system, gold was linked to the US dollar, the dollar in effect became the intervention currency. But the exchange value of the rupee in terms of the pound sterling was not disturbed. When the pound was devalued in 1949, the rupee was devalued to an identical extent. 

However, the devaluation of the rupee in 1949 and later in 1966 led to the reduction of the par value of the rupee in terms of gold.
In 1971, after the USA left the fixed exchange regime, the rupee-pound rate was allowed to fluctuate with reference to the par value of the rupee in terms of the US dollar, even though the gold parity as well as the US dollar parity of the rupee as fixed in June 1966 remained unchanged. This arrangement lasted only from August to December 1971. In December 1971, the pegging of the exchange rate of the rupee to the dollar was given up and a central rate of the rupee as an average of the buying and selling rates of the RBI for the pound came to be adopted. This arrangement continued till September 24, 1975 when the rupee was de-linked from the pound sterling. The rupee was pegged to gold and sterling till 1966, to gold and dollar from 1966 to 1971, and again to sterling from 1971 to 1975. 

From September 25, 1975, the exchange value of the rupee was determined with reference to the daily exchange rate movements of a selected number of currencies of countries that were major trading partners of India. The selection of the currency units and the weights to be assigned to them was left to the discretion of the RBI, subject to the approval of the government. Thus, the rupee came to be linked to an undisclosed basket of currencies. It was undisclosed in order to discourage speculation in the foreign exchange market. Even when the rupee was pegged to the basket of currencies, the pound sterling continued to be the currency of intervention. Under this arrangement, the value of the domestic currency (rupee) with respect to the intervention currency (pound) was changed in line with the movements in the weighted average of the value of the trading partners' currencies vis- a-vis the intervention currency.