What is the Flexible Exchange Rates

With a fully flexible exchange rate adjustment toward the long run equilibrium occurs via a change in relative prices. This effect is shown in Figure below. At point B country A is running an incipient balance of payments deficit. With flexible exchange rates country A's currency will depreciate. Similarly country's currency will appreciate. This change in the terms of trade makes country's goods more competitive and country B's goods less competitive. With no adjustment lags this will cause the demand for country A's goods to increase, and it's IS curve to shift to the right. In country B aggregate demand falls and it's IS curve shifts to the left. These adjustments continue until both economies areas in long run equilibrium at point C.