Explain the mechanism through which internal and external balance takes place under flexible exchange rate.

Advantages of Fixed Exchange Rate Mechanism:

1. Automatic Adjustment in BOP:

The chief merit of the flexible exchange rate is that the BOP disequili­brium gets corrected automatically with the change in exchange rate. If BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. This causes export goods cheaper and import goods dearer.

As a result, export tends to rise while imports tend to decline—thereby removing deficit in the BOP account. Similarly, supply in the BOP account means excess demand for home currency and, thus, rise in the exchange rate. This, in turn, encourages imports and discourages exports.

As a result, the BOP accounts will reach equilibrium by the same logic. Thus, this exchange rate makes an automatic adjustment in the BOP crises of an economy and that too without ____ _______ ___ ________ _______ ________ _______ ________.
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