How exchange rates are determined in freely floating exchange rate systems
A floating exchange rate is the price of one currency in terms of another. Supply and demand in the foreign exchange market set that price automatically, with no government control.
Formula
Exchange Rate = f(Demand for currency / Supply of currency)
Real World
After the Brexit referendum in June 2016, demand for sterling fell sharply as investors lost confidence in the UK economy, causing the pound to drop roughly 15% against the dollar within days — a real-time example of sentiment driving a floating rate.
Exam Focus
Always identify which side of the forex market is shifting (demand or supply) and state the direction of change in the exchange rate before explaining consequences.
Price Elasticity of Demand
PED = % change in quantity demanded ÷ % change in price
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