How is the exchange rate determined under a flexible exchange rate regime?
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How is the exchange rate determined under a flexible exchange rate regime?
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The rate of exchange is controlled by the forces of demand and supply in the international market under a flexible exchange rate framework. In other words, when demand and supply are equal, the equilibrium rate of exchange is reached. The equilibrium rate is also set at a point when the demand for foreign exchange is equal to the supply of the same. The following diagram can assist to illustrate this: The x-axis depicts foreign currency demand and supply, while the y-axis depicts the exchange rate. The downward-sloping demand curve (DD) depicts an inverse relationship between the rate of exchange and demand for foreign currency. The supply curve, on the other hand, is upward sloping, indicating a positive relationship between the rate of exchange and foreign currency supply. E is the exchange rate at which demand and supply of foreign currency are equal (OR). If the exchange rate climbs to OR1, the supply will outstrip the demand, leading the rate to fall back to OR. If the exchange rate falls to OR2, on the other hand, there is an excess of demand oversupply. As a result, the exchange rate rises from R2 to R., demand and supply of foreign currency determine the equilibrium exchange rate (OR). Payment of international loans, gifts, and grants are all sources of foreign exchange demand. Worldwide export, direct foreign investment, and other forms of foreign exchange supplies are examples.
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