How is foreign exchange rate determined under a flexible exchange rate regime?
or
How exchange rate is determined in the foreign exchange market?
Foreign exchange rate is determined by the market forces of demand and supply in foreign exchange market.
The rate of exchange is obtained from the equilibrium exchange rate, which we get when the supply of foreign exchange equals to the demand for foreign exchange.
In the given figure, DD curve represents the demand for foreign exchange and SS curve represents the supply of foreign exchange for different values of R, i.e. rate of exchange. Point E is the equilibrium point, where DD = SS. So, R will be the rate of exchange.
If the rate of exchange is arbitrarily fixed other than R, there will be a situation of either excess demand or excess supply of foreign exchange. So, R is the rate of exchange which corresponds to the equilibrium point E.
