Question : In a floating exchange rate system, the exchange rate is primarily determined by:
Option 1: Market forces of supply and demand.
Option 2: Government interventions.
Option 3: Balance of trade.
Option 4: Interest rate differentials.
Correct Answer:
Market forces of supply and demand.
Solution : The correct answer is a) Market forces of supply and demand.
Under a floating exchange rate regime, the value of a currency is determined by the interaction of market participants, including individuals, businesses, financial institutions, and investors. The exchange rate adjusts based on the relative demand for and supply of a currency in the foreign exchange market.
Market forces such as economic fundamentals, interest rate differentials, inflation rates, capital flows, trade balances, and investor sentiment all contribute to the fluctuation of exchange rates in a floating exchange rate system.
While governments may occasionally intervene in the foreign exchange market to influence their currency's value, in a floating exchange rate system, their interventions are typically limited and aimed at smoothing extreme volatility rather than actively setting or fixing exchange rates.
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