how is currency exchange rate between two countries determined?

Dear Parag, the objective of exchange rate between nations is to make the people of these respective nations indifferent towards investment and market opportunities based differences so that arbitrage is controlled within a very short span. For example, if a parker pen costs $25 in United States and the same pen costs Rs 750 in India, inorder to keep the common man of U.S.A and India indifferent towards both markets, the exchange rate has to be $25=Rs 750 i.e $1=Rs30. This will discourage the Indian man from importing that pen from United States and at the same time discourage the American in U.S.A from exporting it to India.

It is a well known fact that Macdonald Burger is often looked upon as a Benchmark for knowing the exchange rate difference between U.S.A and India because any change in the exchange rate between these two countries is immediately reflected in the price of Macdonald Burger in these two respective countries.

Broadly speaking, it is the demand and supply for a currency that affects the exchange rate.

The laws of supply and demand apply here so that if the price of one currency is too high it will be traded less or not at all until the price is reduced. If it is too low the trading will be intense and soon its price will be raised.

However that only half the story. Goods pass between the two countries in exchange for the money. When the price of a particular kind of goods in one country result in much trade and accumulation of much foreign currency in the home country, the exchange rate for that currency will drop until the effective price of the goods is greater and trade becomes slower.

So it is both the supply of foreign currency and of home made goods that participate in the exchange rate and it depends on the extent (on the average) of all the trading as to whether the exchange rate is stable or about to float up or down.

It is depend on at what rate contracts of these currencies happening in currency market.and rate is affected by supply and demand of a particular currency.