In a system of flexible exchange rates, the exchange rate is determined by the forces of market demand and supply. In this case of flexible exchange rates without central bank intervention, the exchange rate moves to clear the market, to equate the demand for and supply of foreign exchange. In the following figure equilibrium exchange rate is e* which is determined by the forces of demand and supply.
At the initial equilibrium exchange rate e*, suppose there is now an excess demand for foreign exchange. To clear the market, the exchange rate must rise to the equilibrium value e1 as shown in the following figure.
The rise in exchange rate (depreciation) will cause the quantity of import demand to fall since the rupee price of imported goods rises with the exchange rate. Also, the quantity of exports demanded will increase since the rise in the exchange rate makes exports. less expensive to foreigners. At the new equilibrium, the supply and demand for foreign exchange is again equal.
