Exchange rate determination explains how the value of a currency is decided in a floating exchange rate system. In this system, the price of a currency is set by the demand and supply in the global foreign exchange (forex) market, rather than by government control.

Key factors that influence the exchange rate include:

• Interest rates: Higher interest rates attract international investors, which raises the demand for the currency and increases its value.
• Inflation: Higher inflation lowers the purchasing power of a currency, which reduces demand and decreases its value.
• Balance of payments: A surplus in a country’s trade increases demand for its currency, while a deficit reduces it.
• Speculation: If traders expect a currency’s value to change in the future, they buy or sell it today, which shifts current demand and supply.

The equilibrium exchange rate is reached when the quantity of the currency demanded equals the quantity supplied. This process serves as an automatic stabilizer, helping to balance a country’s international trade over time.