Certified Management Accountant Practice Exam

The exchange rate in a flexible exchange rate system is determined by the forces of supply and demand in the foreign exchange market. This system allows the value of currencies to fluctuate freely according to market conditions, reflecting the economic dynamics such as the trading activities between nations, capital flows, and overall market sentiment.

When demand for a currency increases, perhaps due to heightened investment or consumer interest in that country's goods and services, the value of that currency will rise. Conversely, if the supply of a currency increases, for example, due to central banks selling their currency, its value tends to decrease.

This contrast with fixed exchange rate systems where government regulations and interventions set and maintain currency values against each other. In a flexible system, currency values are not pre-determined, enabling the market to dictate fluctuations based on real-time economic indicators and activities. Furthermore, while interest rates can influence exchange rates indirectly by affecting investment flows and economic growth, they do not solely determine the exchange rate. Therefore, the most accurate determinant in a flexible exchange rate system is indeed the interplay of supply and demand.