Flexible Exchange Rate System:
Under the flexible exchange rate system, exchange rates are freely determined on open market primarily by private dealings, and they, like other market prices, vary from day-to-day.
Under the flexible exchange rate system, the first impact of any tendency toward a surplus or deficit in the balance  of payments is on the exchange rate. Surplus in the balance of payments will create an excess demand for the country’s currency and the
exchange rate will tend to rise. On the other hand, deficit in the balance of payments will give rise to an excess supply of the country’s currency and the exchange rate will, hence, tend to fall.
Equilibrium rate is at E. where the demand and supply curves interact. OR is equilibrium exchange rate when demand for the exchange is equal to its supply. OR1 and OR2 are not equilibrium exchange rates. At  OR1, D>S ( ie R1H > R1G)  and at OR2, S > D, ( R2B > R2A ). At R1 and R2, exchange rates there will be pressure  on the prevailing rate to move towards the equilibrium exchange rate ie. towards point E.
Thus, exchange rate, like any other price is determined by demand and supply forces in the foreign exchange market. Any change in demand and supply will result in change in
exchange rate.
Factors influencing the demand and supply in deremination of the Exchange rate:
•  Demand for Foreign Exchange
Foreign Exchange in a country is demanded by people who require foreign exchange for the following:
1. Import of good:
Consumers  as  well  as  capital  goods  are  imported  from  other  countries.  Foreign
Exchange is demanded by people who import these goods.
2. Import of Service.
Services rendered  by  other  countries  which  include  banking,  insurance,  transport,
communication, educational service, etc. are required to be paid in Foreign Exchange.
3. Unilateral Payments.
Donations, gifts,  etc  are  one  side  payments  without  corresponding  returns.  Such
payments create a demand for Foreign Exchange.
4. Export of Capital.
Repayment of debt, purchases of assets in foreign countries , etc all require Foreign
Exchange
•  Supply for Foreign Exchange
Supply of foreign exchange in a country comes from the receipt of its exports. The main sources of supply are:
1. Export of Servies.
Export service in various fields, tourist coming from other countries, communication, transport, insurance, etc are important service which earn and supply foreign exchange.
2. Export of Goods
This constitutes a major source of supply of Foreign Exchange. Both size and price of exports depends on demand and supply and elasticity of goods.
3. Unilateral Receipts.
Payments received in the form of donations, remittance from domestic working abroad,
etc form a part of Foreign Exchange supply.
4. Import of Capital.
Foreign Direct Investment and Portfolio investment , Repayment of debt by foreigners, all increases the supply of Foreign Exchange
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