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

In a flexible exchange rate system, the value of a country's currency is determined by market forces without direct government intervention. Both internal and external balance are key objectives in macroeconomic policy. Internal balance refers to the situation where the economy operates at full employment with stable inflation, while external balance concerns a sustainable level of the current account, ensuring that a country’s exports and imports are in equilibrium. The mechanism through which these balances occur under a flexible exchange rate involves various market adjustments, including changes in exchange rates, interest rates, and the trade balance.

### Internal Balance and Flexible Exchange Rates

The concept of internal balance in a flexible exchange rate system revolves around achieving a stable economy, with full employment and low inflation. Under this system, the primary mechanism for adjusting to changes in demand or supply shocks is through fluctuations in the exchange rate.

When a country faces a positive demand shock, such as an increase in government spending or investment, this leads to higher output and potentially inflationary pressures. To maintain internal balance, the central bank may raise interest rates to curb inflation. Higher interest rates attract foreign capital, leading to an appreciation of the domestic currency. As the currency appreciates, it ________ ___ ______ ________ _______ _________ _________ ________ _______.
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