There is good news for all those people who are planning to go abroad. Be it for higher studies, on a vacation or for any other reason. The cost of their travel is likely to come down as the Indian rupee gathers strength against the US dollar.

Not only that. As the rupee becomes stronger compared to the US dollar, the cost of all the imported goods and services fall down.

Even those who are staying put back home, an appreciating rupee has its benefits. Like the cost of all imports will come down.

Remember that India imports three-fourths of its oil. As the value of dollar goes down importing oil becomes cheaper. Since oil prices are directly related to rise in prices of other goods and commodities in India, their prices will also fall down.

But how can the rupee strengthening in value against the dollar bring about these changes and what exactly does it mean?

Well, in recent years, the Indian economy has become increasingly global. This means economic events that occur far away from our borders have an increasing impact on our markets and economy.

One important way in which the global economy affects India is exchange rates. Exchange rate refers to the value of the Indian rupee vis-a-vis currencies of other nations like say, USA or England or Pakistan.

This article looks at some of the basic forces that determine exchange rates and how they impact financial markets and the economy at large.

There are two main ways in which countries determine their exchange rates: fixed and floating.

A fixed exchange rate, which is what India had before liberalisation (pre-1991), simply means that the government chooses the official exchange rate: say 1 dollar equals 25 rupees. All official exchange of currency has to take place at this fixed rate.

A fixed exchange rate is often associated with strict controls on the use of foreign exchange. It also sees the rise of black markets as individuals try to avoid the official exchange rate. Individuals do it because they think the government-fixed exchange rate gives them less value for their dollars. The black market, hypothetically, can give more than Rs 25 to a dollar.

• The truth about earning in dollars!

A floating exchange rate, by contrast, means that the exchange rate is determined in the foreign exchange markets by the forces of demand and supply. The exchange rate changes from day to day as market forces shift.

In practice, many countries including India now have a hybrid system called 'dirty float'. This is basically a floating rate where the government intervenes from time to time, trying to nudge the exchange rate in one direction or the other.

So what are the forces that affect exchange rate movements? What, in particular, has been causing the rupee to rise in value in recent months?

Buyers of dollars now have to shell out fewer rupees to buy one unit of a dollar. If they had to pay Rs 43 to buy one dollar earlier, they can now get the same dollar for Rs 42 ie they are getting it for a rupee less. This is what is meant by 'rise in the value' of the rupee in recent months.

Let's now look at the factors affecting the foreign exchange rate of currencies of two independent countries.

The most important factor, probably, is how attractive a country's economy is to foreign investors. Every time a foreign bank or company wants to invest in India -- whether it is by buying shares or opening a factory -- it will need to buy rupees. This will increase the demand for rupees in the foreign exchange markets, which will mean the rupee will rise in value.

• Going on a business trip? Here's your checklist 

This is exactly what has been happening in India recently as it has become one of the fastest growing economies in the world. Multinational corporations are eager to get a slice of the action. In the financial year 2006-2007, India received $16 billion dollars in foreign direct investment; this is about three times the previous year's figure.

Another important factor is the interest rate in different countries. If Indian interest rates rise relative to other countries, Indian interest-bearing products become more attractive; this will once again increase demand for the rupee.

For instance, if the rate of interest in the US is only 4 per cent on bank deposits and a fixed deposit in India fetches, say, 10 per cent, the 6 per cent difference between the interest rates of these two countries will attract foreign investors to India. 

In India, the Reserve Bank of India has been raising interest rates in recent months as a way of fighting inflation; this has played a role in the rising value of the rupee.

So what is the impact of a rising rupee on different sectors of the economy? In a nutshell, exporters are hurt and importers celebrate.

The logic is simple: suppose an exporter earns $1 million in foreign exchange. At an exchange rate of 47 rupees to the dollar, this is worth Rs. 4.7 crores while at a rate of 43 rupees it's only worth Rs. 4.3 crores.

This is why stocks of export-intensive technology firms like Infosys have performed relatively poorly in recent weeks. Firms in the textile sector have also been hurt. Both the information technology and the textile sector are export-driven and are hurt whenever the rupee's value increases.

The reason is they get less rupees for the dollars they earn through exports.

The opposite is true for companies with large imports. A stronger rupee means their import bill will fall in rupee terms. In India, the single biggest import is crude oil, and the rising rupee has seen stock market gains for oil marketing companies like IOC and HPCL in recent weeks.

• Want to invest in foreign stocks?

A barrel of oil that had cost them, say Rs 1720 ($1 = Rs 43; cost of one barrel of oil = $40), will now cost them Rs 1,680 ($1 = Rs 42; cost of one barrel of oil = $40), saving Rs 40 per barrel. This saving directly goes into the net profit kitty of oil marketing companies.   

The rising rupee also has a direct impact on consumers who will face lower prices in rupees for imported goods or travelling abroad. For instance a typical weeklong trip abroad costing, say, $1000 (or Rs 42,000; $1 = Rs 42) will be cheaper because of the rise of the rupee in the last six months.

The same trip would have earlier cost Rs 44,000 (assuming $1 = Rs 44).

So what's likely to happen to the rupee in the future?

No one can say for sure as exchange rates are notoriously unpredictable. If the rupee rises significantly, you could see the RBI intervening in the markets and selling rupees in order to lower its value. As of now, it is not doing this, allowing the rupee to increase in value.

However, if India remains an attractive investment destination, the rupee is unlikely to drop significantly from its current level as foreign investments will come pouring in.

But if it does 'rise in value' further then you and I will be able to buy that imported watch, the latest laptop and of course, oil at much cheaper rates than we are doing now.