Explain, how exchange rate is determined under a free market exchange rate system.

The following are the key factors that affect the demand and supply of foreign exchange, and ultimately the exchange rate:

1. Interest Rates: Higher interest rates can attract foreign capital inflows, increasing demand for a currency, and potentially appreciating its value. Conversely, lower interest rates can lead to capital outflows, increasing the supply of a currency, and potentially depreciating its value.

2. Inflation Rates: Currencies of countries with high inflation rates tend to lose their value over time, reducing demand and potentially depreciating their value relative to other currencies.

3. Economic Performance: Strong economic growth, stable political conditions, and positive market sentiment can increase demand for a currency, potentially appreciating its value. Conversely, weak economic performance, political instability, and negative market sentiment can reduce demand for a currency, potentially depreciating its value.

4. Trade Balances: Countries with a trade surplus (exports greater than imports) typically have a higher demand for their currency, potentially appreciating its value. Conversely, countries with a trade deficit (imports greater than exports) typically have a lower demand for their currency, potentially depreciating its value.

The interplay of these factors, along with other variables, such as government policies, geopolitical developments, and market sentiment, ultimately determines the exchange rate in a free market exchange rate system. As such, exchange rates can be highly volatile and subject to sudden shifts based on changing market conditions.