Under a flexible exchange rate regime, the exchange rate is determined by the market forces of demand and supply. This system is also known as the Floating Exchange Rate system.

The exchange rate is determined at the point where the demand curve intersects with the supply curve in the foreign exchange market. On a graph, this equilibrium is represented by point e on the Y-axis, which indicates the exchange rate. The corresponding point q on the X-axis determines the quantity of foreign currency (such as US Dollars) that has been demanded and supplied at that exchange rate.

In a completely flexible system, the Central banks do not intervene in the foreign exchange market. The exchange rate is left entirely to market forces without any official interference or use of reserves.

A major advantage of this system is that movements in the exchange rate automatically take care of the surpluses and deficits in the Balance of Payments. The government does not need to maintain large stocks of foreign exchange reserves. Countries also gain independence in conducting their monetary policies since they do not have to intervene to maintain exchange rates.

When the price of domestic currency (rupees) in terms of foreign currency (dollars) increases under this regime, it is called Appreciation of the domestic currency.