The flexible exchange rate is determined by the interaction of the forces of demand and supply. The equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange. This will be clear from the given Diagram.
As seen in the diagram, demand and supply of foreign exchange are measured on the X-axis whereas the rate of foreign exchange on the Y-axis. DD is the downward sloping demand curve of foreign exchange and SS is the upward-sloping supply curve of foreign exchange. Both the curves intersect each other at point ‘E’. The equilibrium exchange rate is determined at OR and the equilibrium quantity is determined at OQ.
