What is foreign exchange?
The currency of another country is foreign exchange for us. The local currency - Indian Rupee or INR- is the legal tender in India. However when we buy some goods from another country, we have to pay them in their currency or some internationally accepted currency like US Dollar, Euro, etc.
How we get foreign exchange?
Foreign exchange comes to our country when we export goods, when Indian citizen working in other countries (NRIs) send money to India, when Indian companies do business and service to or in other countries and get the payments sent to India etc.
How foreign exchange is kept?
As foreign exchange is not legal tender inside our country, it is just like a commodity to us. The price fluctuates as per demand and supply. So we hold only the bare minimum need foreign exchange with using bank and RBI and keep the excess and extra as investments or bank accounts in the respective countries or international banks and use it whenever needed.
How and why only certain currencies are more preferred and get value and acceptability?
The value and acceptability of a country's currency depends on the country's economic stability and growth, political stability, the quantum of its international business etc.
Can't we buy Dollars in international markets with our Rupees and use those Dollars for purchasing our imports?
Indian currency has not yet become a preferred currency for international business. International banking business takes place through the international currency bank accounts we maintain with established banks in the accepted currency countries. Thus, if our country maintains account with a bank in US in dollars, the amount can be used to finance our imports. Our export payments in USD will get credited to that dollar account . Paying rupee and getting dollars in exchange is possible for individuals and in small amounts. For large payments it is the international bank balances that has to be used.
That is why we need more foreign exchange reserves(or more bank balances in foreign currency in other countries).
How can we improve our foreign exchange reserves?
The main way is to improve exports and reduce imports. However our foreign exchange spending is mostly for the oil import. That is why we were finding it hard to maintain good foreign exchange reserves. More capital flow by way of foreign investment can also improve exchange reserves. But then, the repatriation of capital and profit will also affect it. As of now the NRIs and Indian IT sector help us get foreign exchange. But due to many changes in the laws of other countries, that also gets affected. Tourism is another area which gets us foreign exchange.
It is in this context we should see the "Make in India" campaign. That will make our imports (except probably for oil) less and also improve exports. Voluntary choice of 'Swadeshi' also is a solution to decrease dependence on imported goods and thus foreign exchange spending..
Foreign exchange reserves help us to finance our imports and also get more value to our currency in foreign exchange markets.
(Note: Though there are more technicalities involved in foreign exchange, this answer is given in general terms for easy understanding of an ordinary person)