An exchange rate is the price of one country's money in terms of other country's money. When we say that exchange rate of Indian Rupee is 42.23 per US Dollar (22:13 IST), we mean that 42.23 Indian Rupees are required to purchase one US Dollar. When this exchange rate becomes 43 we say that the value of Indian Rupee depreciated against the US Dollar. On the other hand when the exchange rate becomes 42 we mean that Indian Rupee has appreciated against the US Dollar. Assuming that there are no exogenous factors restricting the changes in exchange rates, their movement can be traced to pure demand and supply. When Indian rupee depreciates against the US Dollar, it indicates that demand for later is more than its supply. Similarly when the supply of US Dollar is more than its demand, it declines in value against the Indian Rupee.

Currency of a country is used for transactions with foreigners. Each country in the world has its own currency. Theoretically, a country should transact with all foreign entities on a one-to-one basis, i.e. for all imports from a foreign country, the host country should be paid in its currency. But practically this is not possible because it involves keeping record of a multitude of exchange rates and associated payment problems. Therefore, most of the countries chose a common currency for trade amongst themselves. The U.S Dollar has emerged as the strongest currency for the past sixty years and as such is used as the payment medium for most of the world trade. In the European Union the Euro has established itself as the common currency of about 25 countries.

It is clear that the currency of a country is evaluated against a common currency for external transactions. In case of countries having dominant economic power, trade would be held in currency. Hence a country is required to trade in U.S Dollar or in other dominant currencies like Euro, Pound or the Japanese Yen. Account of a country's external trade is kept in the form of a balance of payments account which is a double book entry system. Receipts of foreign currencies are credited to this account while payments in foreign currency are debited to this account. The balance sheet in this account shows a positive or a negative figure depending upon whether the receipts of foreign currency are more or less than the payments.

Other things being equal, the presumption is that a country having a deficit balance of pavements position would have a weakening national currency and vice versa. A deficit in the balance of payment account results in more demand for foreign currencies.

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