Question

‘The flexible exchange rate system is a system of automatic adjustment in the balance of payments disequilibrium.’ Explain with the help of a diagram.

Answer 1

In a flexible exchange rate system, the exchange rate is determined by market forces (demand and supply of foreign exchange) without government intervention.

When there is a balance of payments (BoP) disequilibrium (deficit or surplus), the exchange rate automatically adjusts to correct it.

Case 1: BoP Deficit (More Imports, Less Exports)

• High demand for foreign exchange (to pay for imports) causes the domestic currency to depreciate.

• Depreciation makes exports cheaper and imports costlier.

• As a result:
  
  • Exports rise
  • Imports fall
• This helps correct the BoP deficit automatically.

Case 2: BoP Surplus (More Exports, Less Imports)

• A higher supply of foreign exchange causes the domestic currency to appreciate.
• Appreciation makes exports costlier and imports cheaper.
• As a result:
  • Exports fall
  • Imports rise
• This helps correct the BoP surplus automatically.