How is the exchange rate determined under a flexible exchange rate regime?
Under flexible or floating exchange rate regime, the exchange rate is determined by the interaction of market forces of demand and supply of foreign exchange in international market.
Central Bank does not intervene in foreign exchange market in deciding the exchange rate system.
Let us explain it with help of the following diagram
In the above diagram –
•OX represents the Amount of Foreign Exchange
•OY represents the Exchange Rate
•DD is the downward sloping demand curve for foreign exchange
•SS denotes the upward sloping supply curve of foreign exchange
•X is the equilibrium point where demand and supply of foreign exchange are equal
•Oe denotes the equilibrium exchange rate
•Om denotes the equilibrium amount of foreign exchange
Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).