Explain how exchange rate is determined under a free market exchange rate system?

Question: Explain how exchange rate is determined under a free market exchange rate system?

In a free market exchange rate system, exchange rates are determined by the forces of supply and demand. When there is a higher demand for a currency, its value goes up, and when there is a lower demand, its value goes down. Similarly, when there is a higher supply of a currency, its value goes down, and when there is a lower supply, its value goes up. The exchange rate is therefore influenced by various factors, such as interest rates, inflation, trade balances, political stability, and market sentiment, all of which affect the demand and supply of currencies. The market participants, including banks, traders, investors, and governments, determine the exchange rates through their transactions in the foreign exchange market.

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