In a system of flexible exchange rate, the exchange rate of a currency (like price of a commodity) is freely determined by forces of demand and supply of foreign exchange in the foreign exchange market. Expressed graphically, the intersection of demand and the supply curves determines the equilibrium exchange rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market. Let us assume that there are two countries–India and USA – and the exchange rate of their currencies, viz., rupee and dollar is to be determined. Presently, there is floating or flexible exchange regime in both India and USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies as explained below.

(a) Demand for foreign exchange. Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to purchase foreign currency in anticipation of earnings profit (speculation), (vi) to undertake foreign tour, etc. The demand curve is downward sloping due to inverse relationship between foreign exchange rate and its demand vide Fig.(a).