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Question

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


Solution

Flexible exchange rate is determined by the forces of supply and demand in the international market. The equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.

• Sources of demand for foreign exchange

(i) Payment of international loans

(ii) Gifts and grants to rest of the world

• Source of supply of foreign exchange

(i) Export to the rest of the world

(ii) Direct foreign investment

(iii) Direct purchase of goods and services by the non-residents in the domestic market. 

In the figure, the equilibrium exchange rate i.e., E. 

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