Question
Define fixed exchange rate. How is the exchange rate determined in a flexible exchange rate system?
✓
Answer
Fixed exchange rate (also known as pegged exchange rate) is determined by the government and government has complete control over it. Under a fixed exchange rate, the exchange rate remains fixed as determined by the government.
Equilibrium Exchange Rate:
Under a flexible exchange rate regime, the exchange rate is determined by the forces of demand and supply. Demand for foreign exchange arises from the need to make payments in foreign exchange. Demand for foreign exchange varies inversely with the foreign exchange rate. As the foreign exchange rate rises, the demand for foreign exchange falls and vice versa. Supply of foreign exchange arises from the receipts of foreign exchange.
The supply of foreign exchange rate varies directly with the foreign exchange rate. As foreign exchange rate rises, the supply of foreign exchange rises and vice versa.
Equilibrium exchange rate is determined at the point where the demand for foreign exchange is equal to the supply of foreign exchange. Graphically, it is determined at the point where the demand curve for foreign exchange intersects the supply curve of foreign exchange.
According to the graph, the equilibrium is determined at Point E, where the demand curve DD intersects the supply curve SS. Here, the equilibrium exchange rate is OR and the equilibrium quantity of foreign exchange is OQ.
Equilibrium Exchange Rate:
Under a flexible exchange rate regime, the exchange rate is determined by the forces of demand and supply. Demand for foreign exchange arises from the need to make payments in foreign exchange. Demand for foreign exchange varies inversely with the foreign exchange rate. As the foreign exchange rate rises, the demand for foreign exchange falls and vice versa. Supply of foreign exchange arises from the receipts of foreign exchange.
The supply of foreign exchange rate varies directly with the foreign exchange rate. As foreign exchange rate rises, the supply of foreign exchange rises and vice versa.
Equilibrium exchange rate is determined at the point where the demand for foreign exchange is equal to the supply of foreign exchange. Graphically, it is determined at the point where the demand curve for foreign exchange intersects the supply curve of foreign exchange.
According to the graph, the equilibrium is determined at Point E, where the demand curve DD intersects the supply curve SS. Here, the equilibrium exchange rate is OR and the equilibrium quantity of foreign exchange is OQ.
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