Question

Under the flexible exchange rate system, the exchange rate is determined:

• A. By the Central Bank
• B. By the World Trade Organization
• C. Predominantly by market mechanism
• D. As a weighted index of a group of currencies

Hint:

A flexible exchange rate allows currency values to fluctuate according to market conditions.

Answer 1

The Correct Option is C

Under a flexible exchange rate system, the determination of the exchange rate is fundamentally driven by the interaction of supply and demand factors in the international currency markets. Unlike a fixed exchange rate system, where the central authority, such as a central bank, maintains the currency value within a narrow band, a flexible system allows the value of a currency to fluctuate in response to external market forces.

In a flexible exchange rate regime, various factors influence the demand and supply for a currency, including:

• Trade Balances: The difference in value between a country's exports and imports affects the demand for its currency.
• Interest Rates: Higher interest rates offer lenders a better return compared to other countries, increasing demand for that currency.
• Inflation: Low inflation in a country can strengthen its currency value as compared to a country with higher inflation.
• Speculation: Traders who expect future appreciation or depreciation of a currency will buy or sell currencies in anticipation.
• Foreign Investment: Inflows of foreign capital and investment can increase the value of a country's currency.

Therefore, the correct answer is: Predominantly by market mechanism.