ICAI Notes- Unit 4: Exchange Rate and Its Economic Effects | Business Economics for CA Foundation PDF Download

 Page 1


  
 
BUSINESS ECONOMICS 
a
 
 
9.50 
LEARNING OUTCOMES 
UNIT - 4: EXCHANGE RATE AND ITS 
ECONOMIC EFFECTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Define exchange rate and describe how it is determined  
? Appraise different types of exchange rate regimes  
? Describe the functioning of the foreign exchange market 
? Explain changes in exchange rates and their impact on the real 
economy 
 
 
 
 
  
International Trade
Exchange Rate and 
its Economic Effects
The Exchange Rate 
Regimes
Changes in 
Exchange Rates
Devaluation Vs 
Depreciation
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 2


  
 
BUSINESS ECONOMICS 
a
 
 
9.50 
LEARNING OUTCOMES 
UNIT - 4: EXCHANGE RATE AND ITS 
ECONOMIC EFFECTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Define exchange rate and describe how it is determined  
? Appraise different types of exchange rate regimes  
? Describe the functioning of the foreign exchange market 
? Explain changes in exchange rates and their impact on the real 
economy 
 
 
 
 
  
International Trade
Exchange Rate and 
its Economic Effects
The Exchange Rate 
Regimes
Changes in 
Exchange Rates
Devaluation Vs 
Depreciation
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.51 
INTERNATIONAL TRADE 
4.1 INTRODUCTION 
Each day we get fascinating news about the currency which fuel our curiosity, such as Rupee 
gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee down, Euro holds 
steady, Pound strengthens etc. Ever wondered what this jargon mean? We shall try to 
understand a few fundamentals related to currency transactions in this unit. 
In chapter 3, we examined the demand for and supply of domestic currency.  It is not domestic 
currency alone that we need. Households, businesses and governments in India, for example, 
buy different types of goods and services produced in other countries. Similarly, residents of 
the rest of the world buy goods and services from residents in India. Foreign investors, 
businesses, and governments invest in our country, just as our nationals invest in other 
countries. In the same way, lending, and borrowing also take place internationally. These and 
similar other transactions give rise to an international dimension of money, which involves 
exchange of one currency for another. Obviously, this entails market transactions involving 
the determination of price of one currency in terms of another.  
4.2 THE EXCHANGE RATE 
A foreign currency transaction is a transaction that is denominated in or requires settlement 
in a foreign currency, including transactions arising when an enterprise either: 
(a)  buys or sells goods or services whose price is denominated in a foreign currency. 
(b)  borrows or lends funds when the amounts payable or receivable are denominated in a 
foreign currency. 
(c)  becomes a party to an unperformed forward exchange contract; or 
(d)  otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in 
a foreign currency. 
4.3 THE EXCHANGE RATE REGIMES  
Exchange rates are determined by demand and supply. But governments can influence those 
exchange rates in various ways. The extent and nature of government involvement in currency 
markets define alternative systems of exchange rates. In this section, we will examine some 
common systems and explore some of their macroeconomic implications. 
There are three broad categories of exchange rate systems. In one system, exchange rates are 
set purely by private market forces with no government involvement. Values change 
constantly as the demand for and supply of currencies fluctuate. In another system, currency 
© The Institute of Chartered Accountants of India
Page 3


  
 
BUSINESS ECONOMICS 
a
 
 
9.50 
LEARNING OUTCOMES 
UNIT - 4: EXCHANGE RATE AND ITS 
ECONOMIC EFFECTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Define exchange rate and describe how it is determined  
? Appraise different types of exchange rate regimes  
? Describe the functioning of the foreign exchange market 
? Explain changes in exchange rates and their impact on the real 
economy 
 
 
 
 
  
International Trade
Exchange Rate and 
its Economic Effects
The Exchange Rate 
Regimes
Changes in 
Exchange Rates
Devaluation Vs 
Depreciation
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.51 
INTERNATIONAL TRADE 
4.1 INTRODUCTION 
Each day we get fascinating news about the currency which fuel our curiosity, such as Rupee 
gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee down, Euro holds 
steady, Pound strengthens etc. Ever wondered what this jargon mean? We shall try to 
understand a few fundamentals related to currency transactions in this unit. 
In chapter 3, we examined the demand for and supply of domestic currency.  It is not domestic 
currency alone that we need. Households, businesses and governments in India, for example, 
buy different types of goods and services produced in other countries. Similarly, residents of 
the rest of the world buy goods and services from residents in India. Foreign investors, 
businesses, and governments invest in our country, just as our nationals invest in other 
countries. In the same way, lending, and borrowing also take place internationally. These and 
similar other transactions give rise to an international dimension of money, which involves 
exchange of one currency for another. Obviously, this entails market transactions involving 
the determination of price of one currency in terms of another.  
4.2 THE EXCHANGE RATE 
A foreign currency transaction is a transaction that is denominated in or requires settlement 
in a foreign currency, including transactions arising when an enterprise either: 
(a)  buys or sells goods or services whose price is denominated in a foreign currency. 
(b)  borrows or lends funds when the amounts payable or receivable are denominated in a 
foreign currency. 
(c)  becomes a party to an unperformed forward exchange contract; or 
(d)  otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in 
a foreign currency. 
4.3 THE EXCHANGE RATE REGIMES  
Exchange rates are determined by demand and supply. But governments can influence those 
exchange rates in various ways. The extent and nature of government involvement in currency 
markets define alternative systems of exchange rates. In this section, we will examine some 
common systems and explore some of their macroeconomic implications. 
There are three broad categories of exchange rate systems. In one system, exchange rates are 
set purely by private market forces with no government involvement. Values change 
constantly as the demand for and supply of currencies fluctuate. In another system, currency 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.52 
values are allowed to change, but governments participate in currency markets in an effort to 
influence those values. Finally, governments may seek to fix the values of their currencies, 
either through participation in the market or through regulatory policy. 
An exchange rate regime is the system by which a country manages its currency with respect 
to foreign currencies. It refers to the method by which the value of the domestic currency in 
terms of foreign currencies is determined. There are two major types of exchange rate regimes 
at the extreme ends; namely: 
(i) floating exchange rate regime (also called a flexible exchange rate), and  
(ii) fixed exchange rate regime  
In a free-floating exchange rate system, governments and central banks do not participate 
in the market for foreign exchange. The relationship between governments and central banks 
on the one hand and currency markets on the other is much the same as the typical 
relationship between these institutions and stock markets. Governments may regulate stock 
markets to prevent fraud, but stock values themselves are left to float in the market.  
A free-floating system has the advantage of being self-regulating. There is no need for 
government intervention if the exchange rate is left to the market. Market forces also restrain 
large swings in demand or supply. Suppose, for example, that a dramatic shift in world 
preferences led to a sharply increased demand for goods and services produced in Canada. 
This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make 
Canadian goods and services more expensive for foreigners to buy. Some of the impact of the 
swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-
floating exchange rate acts as a buffer to insulate an economy from the impact of international 
events. 
The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts 
between buyers and sellers in different countries must not only reckon with possible changes 
in prices and other factors during the lives of those contracts, they must also consider the 
possibility of exchange rate changes. An agreement by an Indian distributor to purchase a 
certain quantity of US goods each year, for example, will be affected by the possibility that 
the exchange rate between the Indian rupee and the U.S. dollar will change while the contract 
is in effect. Fluctuating exchange rates make international transactions riskier and thus 
increase the cost of doing business with other countries. 
Managed Float Systems 
Governments and central banks often seek to increase or decrease their exchange rates by 
buying or selling their own currencies. Exchange rates are still free to float, but governments 
try to influence their values. Government or central bank participation in a floating exchange 
rate system is called a managed float. 
© The Institute of Chartered Accountants of India
Page 4


  
 
BUSINESS ECONOMICS 
a
 
 
9.50 
LEARNING OUTCOMES 
UNIT - 4: EXCHANGE RATE AND ITS 
ECONOMIC EFFECTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Define exchange rate and describe how it is determined  
? Appraise different types of exchange rate regimes  
? Describe the functioning of the foreign exchange market 
? Explain changes in exchange rates and their impact on the real 
economy 
 
 
 
 
  
International Trade
Exchange Rate and 
its Economic Effects
The Exchange Rate 
Regimes
Changes in 
Exchange Rates
Devaluation Vs 
Depreciation
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.51 
INTERNATIONAL TRADE 
4.1 INTRODUCTION 
Each day we get fascinating news about the currency which fuel our curiosity, such as Rupee 
gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee down, Euro holds 
steady, Pound strengthens etc. Ever wondered what this jargon mean? We shall try to 
understand a few fundamentals related to currency transactions in this unit. 
In chapter 3, we examined the demand for and supply of domestic currency.  It is not domestic 
currency alone that we need. Households, businesses and governments in India, for example, 
buy different types of goods and services produced in other countries. Similarly, residents of 
the rest of the world buy goods and services from residents in India. Foreign investors, 
businesses, and governments invest in our country, just as our nationals invest in other 
countries. In the same way, lending, and borrowing also take place internationally. These and 
similar other transactions give rise to an international dimension of money, which involves 
exchange of one currency for another. Obviously, this entails market transactions involving 
the determination of price of one currency in terms of another.  
4.2 THE EXCHANGE RATE 
A foreign currency transaction is a transaction that is denominated in or requires settlement 
in a foreign currency, including transactions arising when an enterprise either: 
(a)  buys or sells goods or services whose price is denominated in a foreign currency. 
(b)  borrows or lends funds when the amounts payable or receivable are denominated in a 
foreign currency. 
(c)  becomes a party to an unperformed forward exchange contract; or 
(d)  otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in 
a foreign currency. 
4.3 THE EXCHANGE RATE REGIMES  
Exchange rates are determined by demand and supply. But governments can influence those 
exchange rates in various ways. The extent and nature of government involvement in currency 
markets define alternative systems of exchange rates. In this section, we will examine some 
common systems and explore some of their macroeconomic implications. 
There are three broad categories of exchange rate systems. In one system, exchange rates are 
set purely by private market forces with no government involvement. Values change 
constantly as the demand for and supply of currencies fluctuate. In another system, currency 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.52 
values are allowed to change, but governments participate in currency markets in an effort to 
influence those values. Finally, governments may seek to fix the values of their currencies, 
either through participation in the market or through regulatory policy. 
An exchange rate regime is the system by which a country manages its currency with respect 
to foreign currencies. It refers to the method by which the value of the domestic currency in 
terms of foreign currencies is determined. There are two major types of exchange rate regimes 
at the extreme ends; namely: 
(i) floating exchange rate regime (also called a flexible exchange rate), and  
(ii) fixed exchange rate regime  
In a free-floating exchange rate system, governments and central banks do not participate 
in the market for foreign exchange. The relationship between governments and central banks 
on the one hand and currency markets on the other is much the same as the typical 
relationship between these institutions and stock markets. Governments may regulate stock 
markets to prevent fraud, but stock values themselves are left to float in the market.  
A free-floating system has the advantage of being self-regulating. There is no need for 
government intervention if the exchange rate is left to the market. Market forces also restrain 
large swings in demand or supply. Suppose, for example, that a dramatic shift in world 
preferences led to a sharply increased demand for goods and services produced in Canada. 
This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make 
Canadian goods and services more expensive for foreigners to buy. Some of the impact of the 
swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-
floating exchange rate acts as a buffer to insulate an economy from the impact of international 
events. 
The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts 
between buyers and sellers in different countries must not only reckon with possible changes 
in prices and other factors during the lives of those contracts, they must also consider the 
possibility of exchange rate changes. An agreement by an Indian distributor to purchase a 
certain quantity of US goods each year, for example, will be affected by the possibility that 
the exchange rate between the Indian rupee and the U.S. dollar will change while the contract 
is in effect. Fluctuating exchange rates make international transactions riskier and thus 
increase the cost of doing business with other countries. 
Managed Float Systems 
Governments and central banks often seek to increase or decrease their exchange rates by 
buying or selling their own currencies. Exchange rates are still free to float, but governments 
try to influence their values. Government or central bank participation in a floating exchange 
rate system is called a managed float. 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.53 
INTERNATIONAL TRADE 
Countries that have a floating exchange rate system intervene from time to time in the 
currency market in an effort to raise or lower the price of their own currency. Typically, the 
purpose of such intervention is to prevent sudden large swings in the value of a nation’s 
currency. Such intervention is likely to have only a small impact, if any, on exchange rates.  
Still, governments or central banks can sometimes influence their exchange rates. Suppose 
the price of a country’s currency is rising very rapidly. The country’s government or central 
bank might seek to hold off further increases in order to prevent a major reduction in net 
exports. An announcement that a further increase in its exchange rate is unacceptable, 
followed by sales of that country’s currency by the central bank in order to bring its exchange 
rate down, can sometimes convince other participants in the currency market that the 
exchange rate will not rise further. That change in expectations could reduce demand for and 
increase the supply of the currency, thus achieving the goal of holding the exchange rate 
down. 
Fixed Exchange Rates 
In a fixed exchange rate system, the exchange rate between two currencies is set by 
government policy. There are several mechanisms through which fixed exchange rates may 
be maintained. Whatever the system for maintaining these rates, however, all fixed exchange 
rate systems share some important features. 
In an open economy, the main advantages of a fixed rate regime are: 
(i) A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks 
and transaction costs that can impede international flow of trade and investments. 
International trade and investment are less risky under fixed rate regime as profits are 
not affected by the exchange rate fluctuations. 
(ii) A fixed exchange rate can thus, greatly enhance international trade and investment.  
(iii) A reduction in speculation on exchange rate movements if everyone believes that 
exchange rates will not change. 
(iv) A fixed exchange rate system imposes discipline on a country’s monetary authority and 
therefore is more likely to generate lower levels of inflation. 
(v) The government can encourage greater trade and investment as stability encourages 
investment.  
(vi) Exchange rate peg can also enhance the credibility of the country’s monetary -policy. 
(vii) However, in the fixed or managed floating exchange rate regimes (where the market 
forces are allowed to determine the exchange rate within a band), the central bank is 
required to stand ready to intervene in the foreign exchange market and, also to 
maintain an adequate amount of foreign exchange reserves for this purpose. 
© The Institute of Chartered Accountants of India
Page 5


  
 
BUSINESS ECONOMICS 
a
 
 
9.50 
LEARNING OUTCOMES 
UNIT - 4: EXCHANGE RATE AND ITS 
ECONOMIC EFFECTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Define exchange rate and describe how it is determined  
? Appraise different types of exchange rate regimes  
? Describe the functioning of the foreign exchange market 
? Explain changes in exchange rates and their impact on the real 
economy 
 
 
 
 
  
International Trade
Exchange Rate and 
its Economic Effects
The Exchange Rate 
Regimes
Changes in 
Exchange Rates
Devaluation Vs 
Depreciation
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.51 
INTERNATIONAL TRADE 
4.1 INTRODUCTION 
Each day we get fascinating news about the currency which fuel our curiosity, such as Rupee 
gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee down, Euro holds 
steady, Pound strengthens etc. Ever wondered what this jargon mean? We shall try to 
understand a few fundamentals related to currency transactions in this unit. 
In chapter 3, we examined the demand for and supply of domestic currency.  It is not domestic 
currency alone that we need. Households, businesses and governments in India, for example, 
buy different types of goods and services produced in other countries. Similarly, residents of 
the rest of the world buy goods and services from residents in India. Foreign investors, 
businesses, and governments invest in our country, just as our nationals invest in other 
countries. In the same way, lending, and borrowing also take place internationally. These and 
similar other transactions give rise to an international dimension of money, which involves 
exchange of one currency for another. Obviously, this entails market transactions involving 
the determination of price of one currency in terms of another.  
4.2 THE EXCHANGE RATE 
A foreign currency transaction is a transaction that is denominated in or requires settlement 
in a foreign currency, including transactions arising when an enterprise either: 
(a)  buys or sells goods or services whose price is denominated in a foreign currency. 
(b)  borrows or lends funds when the amounts payable or receivable are denominated in a 
foreign currency. 
(c)  becomes a party to an unperformed forward exchange contract; or 
(d)  otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in 
a foreign currency. 
4.3 THE EXCHANGE RATE REGIMES  
Exchange rates are determined by demand and supply. But governments can influence those 
exchange rates in various ways. The extent and nature of government involvement in currency 
markets define alternative systems of exchange rates. In this section, we will examine some 
common systems and explore some of their macroeconomic implications. 
There are three broad categories of exchange rate systems. In one system, exchange rates are 
set purely by private market forces with no government involvement. Values change 
constantly as the demand for and supply of currencies fluctuate. In another system, currency 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.52 
values are allowed to change, but governments participate in currency markets in an effort to 
influence those values. Finally, governments may seek to fix the values of their currencies, 
either through participation in the market or through regulatory policy. 
An exchange rate regime is the system by which a country manages its currency with respect 
to foreign currencies. It refers to the method by which the value of the domestic currency in 
terms of foreign currencies is determined. There are two major types of exchange rate regimes 
at the extreme ends; namely: 
(i) floating exchange rate regime (also called a flexible exchange rate), and  
(ii) fixed exchange rate regime  
In a free-floating exchange rate system, governments and central banks do not participate 
in the market for foreign exchange. The relationship between governments and central banks 
on the one hand and currency markets on the other is much the same as the typical 
relationship between these institutions and stock markets. Governments may regulate stock 
markets to prevent fraud, but stock values themselves are left to float in the market.  
A free-floating system has the advantage of being self-regulating. There is no need for 
government intervention if the exchange rate is left to the market. Market forces also restrain 
large swings in demand or supply. Suppose, for example, that a dramatic shift in world 
preferences led to a sharply increased demand for goods and services produced in Canada. 
This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make 
Canadian goods and services more expensive for foreigners to buy. Some of the impact of the 
swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-
floating exchange rate acts as a buffer to insulate an economy from the impact of international 
events. 
The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts 
between buyers and sellers in different countries must not only reckon with possible changes 
in prices and other factors during the lives of those contracts, they must also consider the 
possibility of exchange rate changes. An agreement by an Indian distributor to purchase a 
certain quantity of US goods each year, for example, will be affected by the possibility that 
the exchange rate between the Indian rupee and the U.S. dollar will change while the contract 
is in effect. Fluctuating exchange rates make international transactions riskier and thus 
increase the cost of doing business with other countries. 
Managed Float Systems 
Governments and central banks often seek to increase or decrease their exchange rates by 
buying or selling their own currencies. Exchange rates are still free to float, but governments 
try to influence their values. Government or central bank participation in a floating exchange 
rate system is called a managed float. 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.53 
INTERNATIONAL TRADE 
Countries that have a floating exchange rate system intervene from time to time in the 
currency market in an effort to raise or lower the price of their own currency. Typically, the 
purpose of such intervention is to prevent sudden large swings in the value of a nation’s 
currency. Such intervention is likely to have only a small impact, if any, on exchange rates.  
Still, governments or central banks can sometimes influence their exchange rates. Suppose 
the price of a country’s currency is rising very rapidly. The country’s government or central 
bank might seek to hold off further increases in order to prevent a major reduction in net 
exports. An announcement that a further increase in its exchange rate is unacceptable, 
followed by sales of that country’s currency by the central bank in order to bring its exchange 
rate down, can sometimes convince other participants in the currency market that the 
exchange rate will not rise further. That change in expectations could reduce demand for and 
increase the supply of the currency, thus achieving the goal of holding the exchange rate 
down. 
Fixed Exchange Rates 
In a fixed exchange rate system, the exchange rate between two currencies is set by 
government policy. There are several mechanisms through which fixed exchange rates may 
be maintained. Whatever the system for maintaining these rates, however, all fixed exchange 
rate systems share some important features. 
In an open economy, the main advantages of a fixed rate regime are: 
(i) A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks 
and transaction costs that can impede international flow of trade and investments. 
International trade and investment are less risky under fixed rate regime as profits are 
not affected by the exchange rate fluctuations. 
(ii) A fixed exchange rate can thus, greatly enhance international trade and investment.  
(iii) A reduction in speculation on exchange rate movements if everyone believes that 
exchange rates will not change. 
(iv) A fixed exchange rate system imposes discipline on a country’s monetary authority and 
therefore is more likely to generate lower levels of inflation. 
(v) The government can encourage greater trade and investment as stability encourages 
investment.  
(vi) Exchange rate peg can also enhance the credibility of the country’s monetary -policy. 
(vii) However, in the fixed or managed floating exchange rate regimes (where the market 
forces are allowed to determine the exchange rate within a band), the central bank is 
required to stand ready to intervene in the foreign exchange market and, also to 
maintain an adequate amount of foreign exchange reserves for this purpose. 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.54 
Basically, the free floating or flexible exchange rate regime is argued to be efficient and highly 
transparent as the exchange rate is free to fluctuate in response to the supply of and demand 
for foreign exchange in the market and clears the imbalances in the foreign exchange market 
without any control of the central bank or the monetary authority. A floating exchange rate 
has many advantages:   
(i) A floating exchange rate has the greatest advantage of allowing a Central bank and/or 
government to pursue its own independent monetary policy. 
(ii) Floating exchange rate regime allows exchange rate to be used as a policy tool: for 
example, policy-makers can adjust the nominal exchange rate to influence the 
competitiveness of the tradable goods sector. 
(iii) As there is no obligation or necessity to intervene in the currency markets, the central 
bank is not required to maintain a huge foreign exchange reserves.  
However, the greatest disadvantage of a flexible exchange rate regime is that volatile 
exchange rates generate a lot of uncertainties in relation to international transactions and add 
a risk premium to the costs of goods and assets traded across borders.  In short, a fixed rate 
brings in more currency and monetary stability and credibility; but it lacks flexibility. On the 
contrary, a floating rate has greater policy flexibility; but less stability. 
4.4 NOMINAL VERSUS REAL EXCHANGE RATES 
We have been discussing so far about nominal exchange rate which refers to the rate at which 
a person can trade the currency of one country for the currency of another country. For any 
country, there are many nominal exchange rates because its currency can be used to purchase 
many foreign currencies. While studying exchange rate changes, economists make use of 
indexes that average these many exchange rates. An exchange rate index turns these many 
exchange rates into a single measure of the international value of currency.  
Nominal Exchange Rates can be used to find the domestic price of foreign goods. However, 
trade flows are affected not by nominal exchange rates, but instead, by real exchange rates. 
The person or firm buying another currency is interested in what can be bought with it. 
The real exchange rate is the rate at which a person can trade the goods and services of one 
country for the goods and services of another.  It describes ‘how many’ of a good or service 
in one country can be traded for ‘one’ of that good or service in a fo reign country. A country’s 
real exchange rate is a key determinant of its net exports of goods and services.   
For calculating real exchange rate, in the case of trade in a single good, we must first use the 
nominal exchange rate to convert the prices into a common currency. The real exchange rate 
© The Institute of Chartered Accountants of India