FIGURE 1 THE FOREIGN EXCHANGE MARKET FOR DOLLARS
A market for foreign exchange is shown here. The horizontal axis measures the quantity of dollars available for foreign exchange, and the vertical axis measures the exchange rate in pounds per dollar. If exchange rates are fully flexible and the exchange rate is initially e1, there is excess demand for dollars: Q2 minus Q1. The dollar will appreciate and the exchange rate will move to e0. Alternatively, if the exchange rate is initially e2, there is an excess supply of dollars. Because there are more dollars being offered than demanded, the dollar will depreciate. Eventually, the market will settle into an exchange rate of e0, where precisely the quantity of dollars supplied is the quantity demanded.