91Ó°ÊÓ

In a flexible exchange rate system, exchange rates are determined by the demand for and supply of individual national currencies in the foreign exchange market.

Thus, the equilibrium is obtained due to market forces of supply and demand. The volatility of flexible exchange rates may have several negative consequences, including discouraging international trade, worsening a nation's terms of trade, and destabilizing a nation's domestic economy by depressing export industries.

The Swiss watchmaker imports watch components from Sweden, which means that the supply of dollars from Switzerland's official reserves is deteriorating (or the demand for dollars are increasing because everyone trades in dollars) and getting transferred to Sweden's economy.

While the export of watches manufactured in Switzerland will create an inflow of dollars (if the exchange of currency is not considered and assumed that Americans are paying in dollars) back into the Swiss economy.

A depreciation in dollars means (and appreciation of Swedish Krona), the Swiss watchmaker will require more dollar reserves to purchase the same quantity of components from the market of Sweden. In addition to that, since export pays for import, export of the same number of watches will create less inflow of dollars back to Switzerland.

Thus, consequently, the dollar depreciation will reduce imports of components from Sweden and the export of watches to the United States. The net effect will be a decline in the manufacturing of Swiss watches.