Q.How is the exchange rate determined under a flexible exchange rate regime?

Under a flexible (or floating) exchange rate regime, the exchange rate is determined by the forces of demand and supply in the foreign exchange market, without any direct intervention by the central bank or government.

The demand for foreign exchange arises when domestic residents need foreign currency to import goods and services, make investments abroad, or send remittances. The supply of foreign exchange comes from exports (foreigners buying domestic goods pay in foreign currency), foreign investment inflows, and remittances from abroad.

The equilibrium exchange rate is established at the point where the demand curve for foreign exchange intersects the supply curve. If demand for foreign currency exceeds supply at the prevailing rate, the domestic currency depreciates (the exchange rate rises). Conversely, if supply exceeds demand, the domestic currency appreciates (the exchange rate falls). These automatic adjustments continue until the market clears. …

The Core Idea: Market Forces at Work

A flexible exchange rate regime treats foreign currency like any other commodity traded in a market. The price of one currency in terms of another — the exchange rate — rises and falls based on how much people want to buy or sell that currency. No central bank steps in to fix or defend a particular rate; the market clears on its own.

Think of it this way: if Indian importers suddenly want more dollars to pay for American goods, they bid up the price of the dollar. The rupee depreciates (more rupees per dollar). Conversely, if American tourists flock to India and need rupees, demand for rupees rises and the rupee appreciates (fewer rupees per dollar). The exchange rate is simply the equilibrium price that balances these competing demands.

Demand for Foreign Currency

Demand for foreign currency (say, US dollars) arises from transactions that require payment in that currency:

• Imports of goods and services: Indian consumers and firms buying American products need dollars.
• Foreign investment: Indian residents purchasing foreign assets — stocks, bonds, real estate abroad — demand foreign currency.
• Remittances and transfers: Sending money to family or institutions overseas.
• Speculation: Traders expecting the foreign currency to appreciate may buy it now to sell later at a profit.

The demand curve for foreign currency slopes downward. When the rupee price of a dollar is high (say, ₹85 per dollar), imports become expensive and fewer people want dollars; when it is low (₹70 per dollar), imports are cheaper and demand for dollars rises.

Supply of Foreign Currency

Supply of foreign currency comes from transactions that bring foreign currency into the domestic market:

• Exports of goods and services: Foreign buyers pay Indian exporters in dollars (or other foreign currency), which exporters then sell for rupees.
• Foreign investment inflows: Foreigners investing in India — buying Indian stocks, bonds, or setting up businesses — supply foreign currency.
• Remittances from abroad: Indians working overseas send money home.
• Foreign tourism: Tourists visiting India exchange their currency for rupees.

The supply curve for foreign currency slopes upward. At a higher rupee price of the dollar (rupee depreciation), Indian goods become cheaper for foreigners, exports rise, and more dollars flow in; at a lower price, exports fall and fewer dollars are supplied.

Equilibrium: Where Demand Meets Supply

The exchange rate settles at the point where the quantity of foreign currency demanded equals the quantity supplied. This is the equilibrium exchange rate.

Suppose at ₹80 per dollar, Indians want to buy $100 million but foreigners are supplying only $80 million. The shortage of dollars pushes the rupee price up — say, to ₹82 per dollar. At this higher rate, imports become costlier (reducing demand for dollars) and exports become more competitive (increasing supply of dollars) until the market balances.

Factors That Shift Demand and Supply

Several underlying factors cause the demand and supply curves themselves to shift, leading to sustained changes in the equilibrium exchange rate:

• Relative inflation rates: If India's inflation is higher than the US, Indian goods become less competitive, reducing export supply of dollars and increasing import demand for dollars — the rupee depreciates. …