In an open economy with a foreign exchange market, currency exchange rates between two countries are primarily determined by which fundamental factor?

Introduction / Context:
Exchange rates tell you how much of one currency you can obtain in terms of another, for example how many rupees per dollar. Understanding what determines these rates is important in economics, international trade, travel, and investment. There are many influences on exchange rates, but most modern economies allow currencies to be traded in markets where prices are largely set by supply and demand. This question asks you to identify the fundamental factor behind exchange rate determination in such systems.

Given Data / Assumptions:

• The topic is currency exchange rates.
• The context is a foreign exchange market in an open economy.
• Options mention randomness, tourist preferences, arbitrary government choice, and supply and demand.
• We assume a system that is mainly market driven rather than a strictly fixed rate regime.

Concept / Approach:
In a flexible or managed float exchange rate system, the price of one currency in terms of another is determined by how much of the currency is being supplied and how much is being demanded at any moment. Demand for a currency depends on factors such as exports, investment inflows, interest rates, and confidence, while supply reflects imports, capital outflows, and other payments. Although governments and central banks can intervene at times, the underlying mechanism is still that of a market where buyers and sellers interact. Therefore, the correct answer links exchange rates with supply and demand for currencies.

Step-by-Step Solution:
Step 1: Remember that a foreign exchange market is a place, physical or electronic, where currencies are traded like any other commodity. Step 2: In any competitive market, prices normally adjust to balance the quantity supplied and the quantity demanded. Step 3: Apply this principle to currencies and recognise that the exchange rate is the price at which one currency trades against another. Step 4: Understand that although governments can influence exchange rates, especially in fixed or managed regimes, they still react to underlying market forces. Step 5: Conclude that the most accurate fundamental factor from the options is the supply of and demand for currencies in the foreign exchange market.

Verification / Alternative check:
You can verify this by recalling basic demand and supply diagrams in economics. When demand for a currency increases, for example due to higher exports or investment, and supply stays the same, the price of that currency in terms of others tends to rise. Conversely, if the supply of a currency increases sharply without a matching rise in demand, its value tends to fall. These movements are often reflected in daily exchange rate changes reported in financial news, confirming the role of market forces.

Why Other Options Are Wrong:
Option a is incorrect because exchange rates do not move in a purely random way; they respond to economic events and market expectations. Option b exaggerates the role of tourists, who are only one small component of overall currency demand. Option c suggests governments alone choose values without markets, which is not true for most modern economies and would still be constrained by market pressures even in more controlled regimes.

Common Pitfalls:
A common mistake is to think that governments simply declare exchange rates without any market influence. Another pitfall is to focus on a single group such as tourists and ignore larger flows like trade and capital movements. Understanding that exchange rates, like other prices, are fundamentally shaped by supply and demand in the foreign exchange market helps you avoid these misconceptions.

Final Answer:
Currency exchange rates are primarily based on the supply of and demand for different currencies in the foreign exchange market.