The two types of foreign exchange system we are looking
at are the fixed and the flexible exchange rate system. The nominal
exchange rate is the price of the domestic currency against the
foreign currency.
In a flexible exchange rate system, the exchange rate is allowed to
adjust to equate the demand for and supply of foreign currency.
Market forces therefore determine the exchange rate. In a clean
float, the exchange rate will adjust to make the current and capital
account sum up to zero. A BOP surplus will result in an
appreciation of the domestic currency i.e. a decrease in the nominal
exchange rate E, while a BOP deficit will result in a depreciation of
the domestic currency i.e. an increase in the nominal exchange rate,
E.
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