The RBI acts as the custodian of the country’s interchange reserves manage exchange control and acts as the agent of the govt in respect of India’s membership of the IMF. Exchange control was first imposed in India in September 1939 at the outbreak of world war II and has been continued since. Under it, control was imposed on both the receipts and payments of exchange.
RBI controls foreign exchange through money supply policies and rate changes.
RBI has currencies of several countries in its reserves depending upon their demands by its local citizens and their net worth. When there is a depreciation within the economy i.e. capital or goods inflow exceed the outflow of a rustic than the worth of that country, say India falls against the importing country, say USA. This reduced worth of INR against USD induces the users of INR to spend extra money than they were spending earlier for the identical basket of products within the international market. As a result, the demand for cash in hand or money increases among citizens and this demand is met in two ways:
1. Rate of interest changes: when demand for money increases then RBI can increase the interest rate that provokes the citizens to deposit more cash in banks and luxuriate in an interest-stricken sum in future than holding extra cash presently. The second impact it has foreign investors to foresee to take a position in your country than in the other if return wages investment is higher here. This increases the capital inflow and helps in improving the balance of trade. But because of earlier noted depreciation as domestic goods become cheaper for Americans relatively, they import such goods and this can be why equilibrium isn't completely restored in an exceedingly short span. Moreover, the matter during this process is that the indisputable fact that increase in rate by RBI results in fall in output within the short run.
2. Changes in Money Supply: RBI can also alter the provision of domestic currency or foreign currency in the domestic market through purchase and sale of bonds issued by them in the open market. When demand increases for money, a rise in the supply of the identical results in fall in the rate of interest but an increase in output. within the long term, this increase in the money supply leads to an increase in nominal prices and wages.