Floating or flexible exchange rate is determined by the market forces of demand and supply. In a completely floating exchange rate system, the Central Bank do not interfere in the foreign exchange market. Demand for a foreign currency increases in cases of increased imports or international travels or higher investments in securities of other countries. This increase the exchange rate and depreciates the domestic currency. Depreciation has a positive price impact on exports which increases and negative impact on imports which decreases.

Increase in supply of foreign currency will have which of the following effects on domestic currency?

Appreciation

The correct answer is Appreciation.

An increase in the supply of foreign currency will lead to an appreciation of the domestic currency. This is because when there is more foreign currency available, it becomes less valuable relative to the domestic currency. As a result, the exchange rate will adjust, with the domestic currency appreciating and the foreign currency depreciating.

The other options are incorrect:

• Depreciation: Depreciation occurs when the domestic currency becomes less valuable relative to foreign currencies. An increase in the supply of foreign currency would have the opposite effect, causing the domestic currency to appreciate.
• No effect: An increase in the supply of foreign currency will always have some effect on the exchange rate. In this case, the effect would be to appreciate the domestic currency.
• Devaluation: Devaluation is a deliberate policy action taken by a government to reduce the value of its currency. An increase in the supply of foreign currency is not a deliberate policy action, so it would not be considered devaluation.