Question

How is the flexible rate of exchange determined? Explain.

Hint:

Think of the exchange rate just like the price of any other commodity. Its price is determined where the demand from buyers meets the supply from sellers.

Answer 1

Step 1: Understanding the Concept:
A flexible rate of exchange, also known as a floating exchange rate, is a system where the value of a currency is determined in the foreign exchange market by the free play of market forces of demand and supply, without any intervention by the government or central bank.

Step 2: Forces Determining the Exchange Rate:
The equilibrium exchange rate is determined at the point where the demand for foreign exchange is equal to the supply of foreign exchange. \begin{enumerate} \item Demand for Foreign Exchange: The demand for foreign currency arises from a country's residents who need to make payments abroad. The main sources of demand are: \begin{itemize} \item To import goods and services. \item For tourism and travel abroad. \item To make investments in foreign countries. \item To send unilateral transfers (gifts, remittances) abroad. \end{itemize} The demand curve for foreign exchange is downward sloping. A lower exchange rate (i.e., domestic currency is stronger) makes foreign goods cheaper, so the quantity demanded of foreign currency increases. \item Supply of Foreign Exchange: The supply of foreign currency comes from foreigners who need the domestic currency to make payments in the country. The main sources of supply are: \begin{itemize} \item Receipts from exports of goods and services. \item Inflow of foreign investment (FDI and FII). \item Remittances and gifts from abroad. \end{itemize} The supply curve for foreign exchange is upward sloping. A higher exchange rate (i.e., domestic currency is weaker) makes domestic goods cheaper for foreigners, boosting exports and increasing the quantity supplied of foreign currency. \end{enumerate}

Step 3: Determination with a Diagram:
\begin{center} \begin{tikzpicture}[scale=0.8] \draw[->] (0,0) -- (6,0) node[below] {Quantity of Foreign Exchange}; \draw[->] (0,0) -- (0,5) node[left] {Exchange Rate}; \draw[thick, color=blue] (1,4) -- (4,1) node[right] {DD (Demand)}; \draw[thick, color=green] (1,1) -- (4,4) node[right] {SS (Supply)}; \draw[dashed] (2.5, 2.5) -- (2.5, 0) node[below] {Q*}; \draw[dashed] (2.5, 2.5) -- (0, 2.5) node[left] {R*}; \fill (2.5,2.5) circle (2.5pt) node[right]{E (Equilibrium)}; \end{tikzpicture} \end{center} In the diagram, the Y-axis represents the exchange rate (e.g., Rupees per \$) and the X-axis represents the quantity of foreign exchange. \begin{itemize} \item The demand curve (DD) and supply curve (SS) intersect at point E. \item R* is the equilibrium exchange rate. \item Q* is the equilibrium quantity of foreign exchange traded. \end{itemize} If the exchange rate is above R*, supply will exceed demand, causing the rate to fall. If the rate is below R*, demand will exceed supply, causing the rate to rise. The rate will stabilize only at R*.

Step 4: Final Answer:
Under a flexible system, the exchange rate is determined by the intersection of the demand and supply curves for foreign exchange in the foreign exchange market. The equilibrium rate is the price that equates the quantity of foreign currency demanded with the quantity supplied.