Flexible Exchange Rate: Supply and Demand in the International Market

The statement given, "Flexible exchange rate is determined by the supply and demand of foreign exchange in the international market," is true. In a flexible exchange rate system, the value of a country's currency is determined by the forces of supply and demand in the international foreign exchange market.

Supply and Demand in the Foreign Exchange Market:

The foreign exchange market is where currencies are traded. It is a decentralized market, meaning that it operates globally and does not have a physical location. In this market, participants, such as banks, financial institutions, and individual investors, buy and sell different currencies to facilitate international trade and investment.

The exchange rate is the price at which one currency can be exchanged for another. It represents the value of one currency in terms of another currency. In a flexible exchange rate system, the exchange rate is determined by the interaction of supply and demand for different currencies in the foreign exchange market.

Supply of Foreign Exchange:

The supply of foreign exchange refers to the quantity of a currency that market participants are willing to sell at a given exchange rate. Several factors influence the supply of foreign exchange, including:

1. Exports: The more a country exports, the greater the supply of its currency in the foreign exchange market. Exporters receive payments in their domestic currency, and they may sell these currencies in exchange for foreign currencies.

2. Capital Inflows: When foreign investors invest in a country, they exchange their currencies for the domestic currency, increasing the supply of foreign exchange. Factors such as interest rates, economic stability, and political conditions influence capital inflows.

3. Central Bank Intervention: Central banks can influence the supply of foreign exchange by buying or selling currencies in the foreign exchange market. For example, if a central bank sells its own currency, it increases the supply of that currency in the market.

Demand for Foreign Exchange:

The demand for foreign exchange refers to the quantity of a currency that market participants want to buy at a given exchange rate. Several factors influence the demand for foreign exchange, including:

1. Imports: When a country imports goods and services, it needs to pay in the currency of the exporting country. This creates a demand for foreign exchange to facilitate these transactions.

2. Capital Outflows: When domestic investors want to invest in foreign countries, they need to exchange their domestic currency for foreign currency. Factors such as investment opportunities and diversification needs influence capital outflows.

3. Speculation: Market participants may buy or sell currencies based on their expectations of future exchange rate movements. Speculative demand for foreign exchange can be influenced by economic indicators, political events, and market sentiment.

Equilibrium Exchange Rate:

In the foreign exchange market, the interaction of supply and demand determines the equilibrium exchange rate. If the supply of a currency exceeds the demand, its value will decrease relative to other currencies, leading to a depreciation of the exchange rate. Conversely, if the demand for a currency exceeds the supply, its value will increase, leading to an appreciation of the exchange rate.

The flexible exchange rate system allows the exchange rate to adjust freely based on market forces, ensuring that the quantity of foreign exchange supplied matches the quantity demanded. This flexibility enables the exchange rate to act as a shock absorber, helping to maintain external balance in the economy.

In conclusion, the statement that the flexible exchange rate is determined