This type of exchange rate is determined within a free market, there is no government
intervention, and the exchange rate is free to fluctuate according to market conditions. The
exchange rate is determined by the demand for and the supply of the currency in question.
If we take sterling as an example, the demand for the currency comes from exports,
i.e. overseas residents buying pounds either to buy British goods and services or for
investment purposes. The supply of pounds comes from imports, i.e. UK residents who
are buying foreign currencies to purchase goods and services or for investment purposes
and who are therefore at the same time supplying pounds to the market. The market for
sterling can then be drawn using simple demand and supply diagrams.
In Figure 10.3, the price axis shows the price of £1 in terms of US dollars and the
quantity axis shows the quantity of pounds being bought and sold.
The equilibrium exchange rate is determined by the intersection of demand and
supply at £1 = $2. As this is a totally free market, if any of the conditions in the market
change, the exchange rate will also change.
The demand for and supply of sterling and therefore the exchange rate is affected by:
● changes in the balance of payments
● changes in investment flows
● speculation in the foreign exchange markets.
This analysis can be applied to other currencies.