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FLEXIBLE EXCHANGE RATE:

An exchange rate determined through the unrestricted interaction of supply and demand in the foreign exchange market. Also termed floating exchange rate, this is one of three basic exchange rate policies used by domestic governments to control their exchange rates with the goal of affecting international trade, balance of trade, and balance of payments. This policy is based on the view that the free interplay of market forces is most likely to generate a desireable pattern of international trade. The other two policies are fixed exchange rate and managed flexible exchange rate.
A flexible exchange rate is a "hands off," non-intervening policy that allows the foreign exchange market to adjust to equilibrium through the balance of demand and supply with no explicit government actions. The presumption is that the resulting exchange rate generates a better outcome for international trade, the balance of trade, and the balance of payments than what could be achieved through government intervention. And if a desired pattern of trade is not achieved, then corrective actions can be undertaken through tariffs, import quotas, or other trade policies.

This policy also provides a baseline or benchmark for evaluating government exchange rate policies. Given that a flexible exchange rate results in one pattern of international trade, the question is the pattern achieved through a fixed exchange rate. Do exports and imports increase or decrease? Is the balance of trade surplus or deficit larger or smaller? And what happens to the balance of payments?

The Foreign Exchange Market for Csonds

To illustrate a flexible exchange rate, consider the foreign exchange market for csonds, the national currency of the United Provinces of Csonda, presented in this exhibit. The horizontal axis measures the quantity of csonds exchanged and the vertical axis measures the price of csonds in terms of queolds, the currency of the Republic of Northwest Queoldiola.

The Foreign Exchange Market
The Foreign Exchange Market


The demand for csonds is given by the negatively-sloped demand curve, labeled D. The demand of csonds is then represented by the positively-sloped supply curve, labeled S. The intersection of the demand and supply curves is the equilibrium exchange rate for csonds, in terms of queolds. The exchange rate is 5 queolds per csond, with 100 csonds exchanged.

Like any unrestricted market, the price (exchange rate) in this foreign exchange market adjusts to eliminate shortages and surpluses. A shortage -- quantity demanded exceeds quantity supplied -- induces an increase in the exchange rate. A surplus -- quantity supplied exceeds quantity demanded -- induces a decrease in the exchange rate.

Change in Demand

To illustrate the flexibility of exchange rates in this market, consider shifts in the demand curve.
  • Demand Increase: An increase in demand is seen by a rightward shift of the demand curve. To illustrate this shift, click the [Demand Increase] button. At the existing exchange rate, a market shortage emerges. This market shortage causes an increase in the exchange rate to 6 queolds per csond.

  • Demand Decrease: A decrease in demand is seen by a leftward shift of the demand curve. To illustrate this shift, click the [Demand Decrease] button. In this case, the existing exchange rate generates a market surplus. This market surplus subsequently causes a decrease in the exchange rate to 4 queolds per csond.

Change in Supply

Now consider shifts in the supply curve.
  • Supply Increase: An increase in supply is seen by a rightward shift of the supply curve. To illustrate this shift, click the [Supply Increase] button. At the existing exchange rate, a market surplus emerges. This market surplus causes a decrease in the exchange rate to 4 queolds per csond.

  • Supply Decrease: A decrease in supply is seen by a leftward shift of the supply curve. To illustrate this shift, click the [Supply Decrease] button. In this case, the existing exchange rate generates a market shortage. This market shortage subsequently causes an increase in the exchange rate to 6 queolds per csond.

What it Means for Trade

The interaction between the foreign exchange rate and international trade is a two-way street. The exchange of currencies and the resulting exchange rate depends in part on the flow of international trade. However, the exchange rate also affects the flow of international trade.

A shift in the demand and supply curves in the foreign exchange market can be caused by changes in exports and imports. However, they can also be caused by other factors, such as the flow of international investment funds. In such cases the resulting impact on international trade from movements in the exchange rate are noteworthy.

  • Exchange Rate Increase: An increase in the exchange rate, caused by an increase in demand or a decrease in supply, means more queolds are needed to purchase one csond. This makes the purchase price of Csondan production relatively higher and the purchase price of Queoldiolan production relatively lower. The result is a decrease in the flow of Csonda production purchased by Northwest Queoldiola and an increase in Queoldiolan production purchased by the United Provinces of Csonda. In other words Csonda exports decrease and imports increase, with a decrease in net exports and a movement in the direction of a balance of trade deficit (or a least a smaller surplus).

  • Exchange Rate Decrease: A decrease in the exchange rate, caused by a decrease in demand or an increase in supply, means fewer queolds are needed to purchase one csond. This makes the purchase price of Csondan production relatively lower and the purchase price of Queoldiolan production relatively higher. The result is an increase in the flow of Csonda production purchased by Northwest Queoldiola and a decrease in Queoldiolan production purchased by the United Provinces of Csonda. In other words Csonda exports increase and imports decrease, with an increase in net exports and a movement in the direction of a balance of trade surplus (or a least a smaller deficit).
In that most countries prefer more exports, fewer imports, and a balance of trade surplus, they are generally pleased if a flexible exchange rate policy results in a decrease in the exchange rate, but not so much if an increase in the exchange rate occurs.

For this reason, governments might profess support, in principle, of flexible exchange rates, but in practice usually implement one of two policies of direct intervention in the foreign exchange market -- fixed exchange rate or managed flexible exchange rate.

Two Other Exchange Rate Policies

Two alternatives to a flexible exchange rate policy are fixed exchange rate and managed flexible exchange rate.
  • Fixed Exchange Rate: A fixed exchange rate is an exchange rate that is established at a specific level and maintained through government actions (usually through monetary policy actions of a central bank). To fix an exchange rate, a government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed. A fixed exchange rate typically disrupts the balance of trade and balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.

  • Managed Flexible Exchange Rate: A managed flexible exchange rate, what is also termed a managed float, is an exchange rate that is generally allowed to adjust due to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits.

<= FIXED INVESTMENTFLEXIBLE PRICES =>


Recommended Citation:

FLEXIBLE EXCHANGE RATE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: April 25, 2018].


Check Out These Related Terms...

     | fixed exchange rate | managed flexible exchange rate | exchange rate policies | foreign exchange market | foreign exchange | exchange rate |


Or For A Little Background...

     | international finance | international trade | international economics | foreign trade | balance of trade | money | currency | open economy | closed economy | domestic sector |


And For Further Study...

     | balance of payments | current account | capital account | international market | free trade areas | trade barriers |


Related Websites (Will Open in New Window)...

     | Federal Reserve System | World Trade Organization | North American Free Trade Agreement | General Agreement on Tariffs and Trade | European Union | International Monetary Fund |


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