Question

How is the rate of exchange determined in a flexible exchange rate system?

How is exchange rate determined under the flexible exchange rate system? Explain it by using an appropriate diagram.

Show with the help of a diagram how exchange rate is determined under flexible exchange rate system.

Answer 1

Under a flexible exchange rate system, the rate of exchange is determined by the market forces of demand and supply. The demand curve of foreign exchange is downward sloping, while the supply curve is upward sloping.

1. Downward Sloping Demand Curve: There is an inverse relationship between foreign exchange rate and quantity of foreign exchange demanded. Due to the inverse relationship, the demand curve is downward sloping.
   
2. Upward Sloping Supply Curve: The supply curve is upward sloping due to direct relationship between the foreign exchange rate and the quantity of foreign exchange supplied.
   

Determination of Foreign Exchange Rate:

Under a flexible exchange rate system, the foreign exchange rate is determined by the market forces of demand and supply. In the figure, the X-axis represents the quantity of foreign exchange demanded and supplied, and the Y-axis represents the price per unit of foreign currency.

The exchange rate is determined at the intersection of the demand and supply curves, i.e., at point E. In the diagram, OP₁ is the exchange rate and OQ₁ is the quantity of foreign exchange demanded and supplied. Any rate above or below this rate is a temporary fluctuation, and an equilibrium rate is established at the point of intersection of the two curves.