Question

How is the exchange rate determined under a flexible exchange rate regime?

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

Answer 1

The forces of supply and demand govern the exchange rate in a flexible exchange rate regime. Stated differently, when supply and demand are equal, the exchange rate is said to be in equilibrium. The following figure can be used to explain this:

The figure's x-axis shows the supply and demand for foreign currency, while the y-axis shows the exchange rate. The downward-sloping demand curve, or DD, illustrates the inverse relationship between the demand for foreign currency and the exchange rate. On the other hand, the upward-sloping supply curve indicates a positive correlation between the foreign currency supply and the exchange rate. When demand and supply of foreign exchange (OR) are equal, the equilibrium rate of exchange is denoted as E. The supply will now be greater than the demand, causing the exchange rate to return to OR if it increases to OR₁. Conversely, there is an excess of demand over supply if the exchange rate drops to OR₂. As a result, the exchange rate increases from R₂ to R. Therefore, the supply and demand of foreign money determine the equilibrium exchange rate (OR).