Flexible rates automatically adjust so as eventually to eliminate balance of payments deficits or

surpluses. We can explain this by looking at SS and DD in Figure 3 which merely restate the demand

For and supply of pounds curves from Figure 9.2. The resulting equilibrium exchange rate,

e.g. of $1.5 = ￡1, correctly suggests that there is no balance of payments deficit or surplus. At the

$1.5 = ￡1 exchange rate the quantity of pounds (the Euro) demanded by Americans in order to

Import British (European) goods, buy British transportation and insurance services, and to pay

Interest and dividends on British (European) investments in the United States is equal to the amount

Of pounds (the Euro) supplied by the British in buying American exports, purchasing services from

Americans, and making interest and dividend payments on American investments in Britain. More

Succinctly, there would be no change in official reserves.

Now let us suppose there is a change of tastes such that Americans decide to buy more British

Automobiles. Or we might assume that the American price level has increased relative to Britain

Figure 9.2. Adjustments under flexible exchange rates, fixed exchange rates, and the gold standard

(Europe) or that interest rates have fallen in the United States as compared to Britain (Europe).