The determination of a floating exchange rate refers to how the value of a currency is set by the demand and supply in the global foreign exchange (forex) market, without direct government interference.
The foreign exchange market: This is a global system where currencies are traded by banks, businesses, and investors.
Demand for a currency: A currency is in demand when foreign buyers need it to:
- Purchase exports from that country.
- Invest in local bonds, shares, or property.
- Speculate, hoping the currency value will rise.
When demand increases, the exchange rate rises. When demand decreases, the rate falls.
Supply of a currency: A currency is supplied to the market when residents sell it to:
- Buy imports from other countries.
- Invest in foreign assets or markets.
- Speculate, hoping the currency value will fall.
When the supply increases, the exchange rate falls. When supply decreases, the rate rises.
Equilibrium: The floating exchange rate is set at the point where the quantity demanded equals the quantity supplied.
Diagram components:
- The Y-axis shows the exchange rate (price).
- The X-axis shows the amount of currency.
- The demand curve slopes downward because cheaper currency encourages foreign buying.
- The supply curve slopes upward because a more valuable currency encourages residents to buy foreign goods and investments.
- The equilibrium is the intersection point where the market-determined rate is found.