Determination of Exchange Rate in a Free Market

Exchange rate is determined by demand and supply of foreign exchange (e.g. dollars) in the foreign exchange market.

Demand for foreign exchange arises from imports, foreign investment, gifts, remittances abroad; it falls when exchange rate rises (downward-sloping demand curve).

Supply of foreign exchange comes from exports, foreign investment inflows, tourism, remittances; it rises when exchange rate rises (upward-sloping supply curve).

Equilibrium exchange rate is fixed at the point where demand equals supply of foreign exchange.

Automatic adjustment:
BOP deficit → excess demand for foreign currency → currency depreciates → imports ↓, exports ↑
BOP surplus → excess supply of foreign currency → currency appreciates → imports ↑, exports ↓