Q.Discuss briefly the determination of exchange rate under the flexible exchange rate system.

Under a flexible exchange rate system, the exchange rate is determined by the forces of demand and supply of foreign currency in the foreign exchange market, with no central bank intervention. The price of one currency in terms of another adjusts freely to clear the market.

The demand for foreign currency (say, US dollars) arises from imports of goods and services, outward investments, and speculative outflows. The supply of foreign currency comes from exports, inward investments, and speculative inflows. The equilibrium exchange rate is the rate at which the quantity demanded of foreign currency equals the quantity supplied. …

The Core Idea: Price of a Currency

Think of a currency like any other good. The rupee is a "good" that Indians sell when they import, and that foreigners buy when they export to India. Its price — the exchange rate — is simply the number of rupees needed to buy one unit of a foreign currency (say, one US dollar). Under a flexible exchange rate system, this price is left entirely to the market. No central bank pegs it, no government fixes it. It floats.

The question then becomes: what determines how many rupees a dollar costs? The answer lies in the demand for dollars and the supply of dollars.

Demand for Foreign Currency (Dollars)

Who demands dollars, and why? In India, the demand for dollars arises primarily from:

• Importers who need dollars to pay for foreign goods.
• Investors who want to invest abroad (buy foreign assets, set up factories overseas).
• Tourists travelling abroad.
• Speculators who expect the dollar to appreciate.

The key relationship: When the rupee price of a dollar falls (rupee appreciates), dollars become cheaper for Indians. This increases the quantity of dollars demanded. So the demand curve for dollars slopes downward — a lower price (fewer rupees per dollar) leads to a higher quantity demanded.

Supply of Foreign Currency (Dollars)

Who supplies dollars to the Indian market? The suppliers are those who receive dollars:

• Exporters who sell Indian goods abroad and are paid in dollars.
• Foreign investors investing in India (FDI, FII) — they bring dollars in.
• NRIs sending remittances.
• Speculators who expect the rupee to appreciate.

The supply curve for dollars slopes upward: when the rupee price of a dollar rises (rupee depreciates), exporters get more rupees for each dollar they earn, so they are willing to supply more dollars. A higher exchange rate (more rupees per dollar) thus increases the quantity supplied.

Equilibrium: Where Demand Meets Supply

Put the two curves together. The exchange rate adjusts until the quantity of dollars demanded equals the quantity supplied. At that point, the foreign exchange market clears.

If the exchange rate is above equilibrium (say, Rs 85 per dollar when equilibrium is Rs 80), the quantity supplied of dollars exceeds the quantity demanded. There is a surplus of dollars. Sellers (banks, exporters) compete to sell their dollars, driving the rupee price of a dollar down — the rupee appreciates back toward equilibrium.

If the exchange rate is below equilibrium (say, Rs 75 per dollar), there is a shortage of dollars. Buyers compete, bidding the price up — the rupee depreciates.

This self-correcting mechanism is the hallmark of a flexible system. No one sets the rate; the market does, continuously.

What Shifts the Curves?

The equilibrium rate is not static. Any change in the underlying factors shifts demand or supply, causing a new equilibrium.

• Increase in Indian income → more imports → demand for dollars shifts right → rupee depreciates. …