Business Economics · Balance of payments and exchange rates

Exchange Rate Determination in a Floating System

Updated 11 October 2026 · Fact-checked

In a floating system, the exchange rate is the price of one currency in terms of another, set by demand and supply in the foreign exchange market. It moves until demand equals supply. Shifts come from trade flows, interest rates, inflation, investment flows and expectations. In exam answers, find which curve shifts and in which direction.

Understand Exchange Rate Determination

An exchange rate is the price of one currency in terms of another. For example, ₹85 per US dollar means one dollar costs ₹85. In a floating (flexible) system, the market sets this price. Central banks do not fix it.

Think of the foreign exchange market for one currency, say the rupee. Demand for rupees comes from foreigners who want to buy Indian goods and services, invest in India, or earn interest on Indian assets. Supply of rupees comes from Indians who want to buy foreign goods, invest abroad, or hold foreign assets. They sell rupees to get foreign currency. The equilibrium exchange rate is where the quantity of rupees demanded equals the quantity supplied.

When the rupee becomes more valuable, it appreciates. When it becomes less valuable, it depreciates. In a floating system, use these words. Revaluation and devaluation apply to fixed or pegged systems, where the authorities change the official rate.

The main factors that shift the curves are:

Relative interest rates. Higher interest rates at home attract foreign money. Demand for the currency rises and it appreciates, other things equal.
Relative inflation. Higher inflation at home makes exports dearer and imports cheaper. Demand for the currency falls, supply rises, and it depreciates over time.
Relative incomes and growth. Faster income growth at home raises imports. Supply of the currency rises and it tends to depreciate. Strong growth can also attract investment, which pushes the other way.
Speculation and expectations. If traders expect a currency to rise, they buy it now and push it up. Expectations can be self-fulfilling.
Investment flows. Foreign direct investment and portfolio inflows raise demand for the currency.
Trade balance and competitiveness. Better quality or lower prices for exports raise demand for the currency.

Always say "other things equal". Several factors act at once, so the net effect can go either way. A rate rise caused by tighter policy can also slow the economy, and that effect works against the currency. State your assumption and keep to it.

Key rules to remember

Exchange rate quote: Domestic price of foreign currency = units of domestic currency per 1 unit of foreign currency; Example: ₹85 per $1. A rise in this number means the rupee has depreciated. State which quote you use.
Equilibrium condition: Demand for currency = Supply of currency; The floating rate adjusts until the two are equal. Here the price of the currency means the foreign currency price of one unit of the domestic currency, for example $ per ₹1. It is not the ₹ per $ number. When the price of the currency is above equilibrium, there is excess supply of that currency. When it is below equilibrium, there is excess demand.
Percentage change in exchange rate: % change = (New rate − Old rate) ÷ Old rate × 100; Use the same quote for both rates. With rupees per dollar, a positive result means the rupee has depreciated.
Inverse of a quote: Foreign currency per ₹1 = 1 ÷ (₹ per 1 unit of foreign currency); Use this to switch quotes. The rupee appreciates when ₹ per $ falls, and when $ per ₹ rises.
Direction of shifts (rule): Higher demand for the currency → appreciation; higher supply of the currency → depreciation; Other things equal. Always say which curve shifts first.

How to solve Exchange Rate Determination questions

Use this method for any question on how a floating exchange rate changes.

1Fix the currency and the quote. Say, for example, "rupee per dollar", and decide whether you analyse the rupee market or the dollar market.
2Identify the event: interest rate change, inflation difference, income change, capital flow, or change in expectations.
3Decide who is affected: foreigners buying the currency (demand) or residents selling it (supply).
4Shift the correct curve and give the direction: demand or supply up or down.
5State the new equilibrium: the currency appreciates or depreciates, and the quantity traded may rise or fall.
6Say "other things equal" and mention any opposing effects, such as slower growth after a rate rise.
7If asked, link to business effects: export competitiveness, import costs, foreign debt burden.
8Check your wording: appreciation and depreciation for floating rates, not revaluation or devaluation.

Quickest way: Demand, supply, direction

When to use it: Use in multiple-choice questions and short written parts when you need the direction of a currency move.

Ask: does the event make people want to buy the currency (demand up) or sell it (supply up)?
Demand up or supply down: appreciation. Supply up or demand down: depreciation.
Check the quote. If the quote is domestic currency per foreign unit, appreciation means the number falls.
Scan the options for traps such as "devaluation" or a wrong direction of the curve.

Common mistakes in Exchange Rate Determination

Using devaluation or revaluation for a floating rate
The words sound similar to depreciation and appreciation.
Fix: Floating rates depreciate or appreciate. Devaluation and revaluation are deliberate official changes in a fixed or pegged system.
Reading the quote the wrong way round
A rise in ₹ per $ looks like a stronger rupee because the number is bigger.
Fix: Write the quote in words first. If ₹ per $ rises, the rupee buys fewer dollars, so it has depreciated.
Shifting both curves for one event
Students try to show every effect at once.
Fix: Take the main first-round effect and shift one curve. Add second-round effects separately and label them.
Saying higher interest rates always strengthen a currency
The rule is learned as a fixed law.
Fix: Say it holds other things equal, as higher rates attract capital. If the rise signals weakness or hurts growth, or was expected, the effect can differ.
Confusing the effect of high inflation with a price effect on one good
Inflation is treated as a one-off event rather than relative to other countries.
Fix: Compare domestic inflation with trading partners. It is the relative rate that affects competitiveness and the exchange rate.
Ignoring expectations and speculation
Textbook diagrams focus on trade flows.
Fix: Remember that currency markets are dominated by financial flows. News about future rates or policy can move the rate before any trade changes.

Worked examples

Example 1

Interest rates in India rise while those in the US stay unchanged. Using demand and supply for rupees, explain the likely effect on the rupee per dollar exchange rate, other things equal.

Show the solution

Fix the market: the rupee market. In this market the price of a rupee is its price in dollars, so the price axis is $ per ₹. The question quotes ₹ per $, which is the inverse: ₹ per $ = 1 ÷ ($ per ₹).
Event: Indian interest rates rise relative to US rates, so Indian assets give a higher return.
Foreign investors want more rupee assets, so they need more rupees. Demand for rupees rises (shifts right).
Indian investors have less reason to buy foreign assets, so they sell fewer rupees. Supply of rupees may shift left.
With higher demand and lower supply, the equilibrium price of the rupee, in $ per ₹, rises. The quantity of rupees traded is ambiguous if both curves shift: higher demand raises it and lower supply reduces it. If only demand shifts, the quantity rises.
A higher $ per ₹ is the same as a lower ₹ per $, because ₹ per $ = 1 ÷ ($ per ₹). So the rupee appreciates and the ₹ per $ number falls.

Answer: The rupee appreciates against the dollar, other things equal. Higher relative interest rates raise demand for rupees and may reduce supply. The price of the rupee ($ per ₹) rises, so the ₹ per $ rate falls. If both curves shift, the quantity of rupees traded is ambiguous. The effect may be weaker if the rise was expected or if it slows growth.

Exam tips

Draw a small demand and supply diagram for the currency, with the exchange rate on the vertical axis. Label the axes and the quote.
In written answers, name the curve that shifts first and then the direction of the change in rate. Marks usually go to that chain.
Use the words appreciation and depreciation for floating rates, and state "other things equal".
For multiple-choice questions, check the quote before choosing the direction. Many wrong options reverse it.
When asked to discuss, add one opposing effect, such as the effect of slower growth after a rate rise, and give a conclusion.

Practice questions from Balance of payments and exchange rates

Exchange Rate Determination in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Exchange Rate Determination: frequently asked questions

How is the exchange rate determined in a floating system?

It is set by the demand for and supply of the currency in the foreign exchange market. The rate adjusts until the quantity demanded equals the quantity supplied. Central banks do not set the rate, although they may sometimes intervene.

How does an interest rate rise affect the exchange rate?

Other things equal, a higher domestic interest rate attracts foreign capital. This raises demand for the currency and it appreciates. The effect depends on whether the rise was expected and on its effect on growth.

Does high inflation weaken a currency?

Usually yes, when inflation is higher than in trading partners. Exports become dearer and imports cheaper, so demand for the currency falls and supply rises. The currency tends to depreciate over time.

What is the difference between depreciation and devaluation?

Depreciation is a fall in a currency's value caused by market forces in a floating system. Devaluation is a deliberate official reduction in the value of a currency under a fixed or pegged system.