FLEXIBLE EXCHANGE RATE

FLEXIBLE EXCHANGE RATE

Under the floating or flexible exchange rate, the exchange rate is allowed to vary to international foreign market market influences. Thus government does not intervene , rather in the market forces that determine the exchange rate. In fact, automatic variations in exchange rate consequent upon a change in the market forces are the essence of freely flexible exchange rate. 

A deficit in the balance of payment account means an excess supply of the domestic currency in the world market. As price declines, imbalances are removed. In other words excess supply of domestic currency will automatically cause a fall in the exchange rate and balance of payments balance will be restored. 

Flexible exchange rate mechanism has been explained in the figure where DD and SS are demand and supply curves. When Indian buy US goods there arises supply of dollar and when US people buy Indian goods there occurs demand for rupee. The initial exchange rate RS 40= $1 is determined by the interaction of DD and SS curves in both figures.



An increase in demand for the Indian exporters means an increase in the demand for Indian rupee. Consequently demand curve shifts to DD and the new exchange rate rises to Rs 50 = $1. At this new exchange rate dollar appreciates while rupee depreciates in value (a). 

Next figure shows that the initial exchange rate is Rs 40 =$1. Supply curve shifts to SS1 in response to an increase in demand for US goods. SS1 interacts the demand curve DD at point B and exchange rate drop to Rs 30 =$1.

This means that dollar depreciates while Indian rupee appreciates.

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