Exchange rates: nominal, real and effective, and which way is up

The nominal exchange rate is the price of one currency in terms of another. Say it as ₹80 per $1 and the thing being bought is the dollar; its price is 80 rupees. That sentence settles everything that follows: the dollar is the good, the rupee is the money, and a higher price means the dollar is dearer.

There are two ways to write the same fact, and exams use both without warning.

Two quotes of the same pair are reciprocals: 1 ÷ 80 = 0.0125. Most Indian entrance papers, and international-economics textbooks such as Krugman and Obstfeld, quote the direct way, home currency per foreign unit. Some macroeconomics textbooks (Mankiw’s, for instance) quote foreign currency per unit of home currency, so a rise there means the opposite. If a question does not say, find the definition in its first line, because GATE 2026 spells it out for exactly this reason.

A currency appreciates when it buys more of another currency, and depreciates when it buys less. These words describe a move in a floating rate, one set by the market. When the authorities change an official rate under a fixed or pegged system, the same moves are called revaluation (up) and devaluation (down). Examiners treat the pairs as different: a question that says “devalued” is telling you the government chose it.

Drag the rate below. Watch the two percentage readouts in particular: they are not the same number, and that surprises people.

Go from ₹80 to ₹100. The price of a dollar has risen by 25%, but the rupee has lost only 20% of its dollar value, from $0.0125 to $0.0100. A rise of 25% in one quote is a fall of 20% in the reciprocal. An examiner who writes “the rupee has depreciated by” has to be read carefully.

What a weaker rupee does to prices

Anything priced abroad costs more rupees; anything Indian costs fewer dollars. So a depreciation makes imports dearer and exports cheaper, and an appreciation does the opposite. JAM 2026 tests the wording: when the domestic currency appreciates, domestic goods become more expensive to foreign buyers (true), and foreign goods become cheaper to domestic buyers (so the statement that they become more expensive is false). Hyderabad 2010 asks it with numbers: the yen goes from 100 to 200 per dollar, so the yen has depreciated and Japanese goods are cheaper for Americans, meaning more of them sell in the US.

Conversion questions are the easiest marks in this topic and are still lost to one slip: multiplying when you should divide. A method that cannot fail is to carry the units.

• Hyderabad 2014: a pair of jeans costs $45 and the exchange rate is $1.50 per pound. How many pounds? Write the rate as a fraction that cancels dollars: 45 $ × (1 £ ÷ 1.50 $) = £30.
• GATE 2023: a bottle costs $4 and the rate is 0.02 dollars per rupee. Rupees = 4 $ × (1 ₹ ÷ 0.02 $) = ₹200.

Rule of thumb: when you are given the rate as “A per unit of B” and you hold B, multiply; when you hold A, divide.

Cross rates and triangular arbitrage

A cross rate is the rate between two currencies worked out from each one’s rate against a third. If ₹80 = $1 and $1.25 = £1, then £1 is worth 80 × 1.25 = ₹100. If a bank quotes the pound at ₹103 instead, you can buy dollars with rupees, pounds with the dollars, and rupees with the pounds, ending with more than you began: triangular arbitrage. Slide the pound’s market price and see which way round the triangle pays.

The nominal rate says what a dollar costs. It does not say whether American goods are cheap or dear for an Indian shopper, because that also depends on prices in both countries. The real exchange rate adds them:

When q rises, foreign goods have become dearer relative to ours: a real depreciation, and exports become more competitive. When q falls, a real appreciation. If prices in the two countries rise by the same percentage and e does not move, q does not change, which is what CUET 2022 means by “an exchange rate which also takes into account the relative prices of products”.

Questions never ask you to compute q from price levels. They ask for its change, and for that there is a shortcut. The derivation takes four lines, and the lab inside it is the one to play with.

A key that does not hold up

CUET 2023 (shift 2) gives a 10% nominal depreciation, foreign inflation of 5% and domestic inflation of 20%, and keys “depreciation by 2.5%”. With e in rupees per dollar, %Δq ≈ 10 + 5 − 20 = −5%, a real appreciation (exactly 1.10 × 1.05 ÷ 1.20 − 1 = −3.75%). No option is right under the standard definition, so it is left out of the practice set below. If you meet a similar one, trust the formula, and settle the direction before the size.

The rupee has a different rate against every currency, and they do not all move together. To say whether the rupee is up or down in general, you need one number, and the nominal effective exchange rate (NEER) is exactly that: an average of the bilateral rates, weighted by each partner’s share of the country’s trade, expressed as an index with a base year equal to 100. A real effective exchange rate (REER) goes one step further and adjusts the NEER for differences in price levels, so it is the real exchange rate averaged over partners. Hyderabad 2019 asks for the name of the trade-weighted average: effective exchange rate.

The lab uses three invented partners. The index is a weighted average; a geometric mean is the usual choice because it gives the same answer whichever way round the rates are quoted.

Read a rising REER as a loss of competitiveness. It rises if the rupee strengthens against the weighted basket, or if Indian prices climb faster than partners’, or both. This is why an economy with a stable nominal rate and high inflation sees its REER drift up year after year.

A floating rate is a price, set where the demand for foreign currency equals its supply. Demand for dollars comes from buying imports, travelling abroad, paying off dollar debts and investing abroad. Supply of dollars comes from exports, foreign tourists, remittances and foreigners investing in India. Turn on a shock below and watch the curves shift.

The forces examiners ask about, in the order they appear in papers:

• The current account. A bigger current account deficit means more demand for foreign exchange and puts downward pressure on the home currency (Hyderabad 2015).
• Interest rates. A higher real interest rate at home attracts foreign capital, so the supply of dollars rises and the rupee appreciates (Hyderabad 2019). The later effect on expectations is on the parity page.
• Inflation. Higher inflation at home makes exports dearer and imports cheaper, which weakens the currency in the long run (the PPP argument, derived on the same page).
• The central bank. If the Reserve Bank reduces the supply of rupees on the foreign-exchange market, rupees become scarcer and the rupee appreciates, and American buyers pay more for Indian goods (JNU 2016).
• Two forces at once. When the current account deficit and the capital inflow both rise, the net effect depends on which is larger (UGC NET Dec 2023).

Switch the lab to a fixed rate and the same shocks do not move the price at all: the central bank has to fill the gap from its reserves. That is the link to the balance of payments.

Each set is drawn from the question bank and graded by the paper’s own difficulty. A few questions are left out because the key is wrong or the wording is unclear; the reasons are listed at the top of the source file and, for the real-rate one, in chapter 4.