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 the demand for foreign exchange is equal to the supply of foreign exchange. This will be clear from 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.
Any exchange rate (other than OR) is not the Equilibrium Exchange Rate
(i) If the exchange rate is more than equilibrium rate. If the exchange rate rises to OR2, then demand for foreign exchange will fall to OQ2 and supply will rise to OQ1. It will be a situation of excess supply. As a result, the exchange rate will fall till it again reaches the equilibrium level of OR.
(ii) If the exchange rate is less than the equilibrium rate. If the exchange rate falls to OR1, then demand will rise to OQ1 and supply will fall to OQ2. It will be a case of excess demand. It will push up the exchange rate until it reaches OR.
