Both the size and persistence of a nations balance of payments deficits and surpluses, and the adjustment it must make to correct these imbalances, depends on the system of exchange rates being used. There are two pure types of exchange rate systems! " flexible or floating exchange rate system, by which the rate that national currencies are exchanged for one another is determined by the forces of demand and supply. #n such a system, no go$ernment inter$ention occurs. " fixed exchange rate system, by which go$ernments determine the rates at which currencies are exchanged and make necessary adjustments in their economies to ensure that these rates continue. Flexible Exchange Rates and the Balance of Payments %roponents of a flexible exchange rate system argue that flexible exchange rates automatically adjust to e$entually eliminate balance of payment deficits or surpluses. To see this, suppose that tastes and preferences in one country for another countries goods changes &i.e. suppose it increases'. (eteris paribus, domestic demand for that countrys currency increases &i.e. domestic demand for foreign exchange rises'. This shifts the demand for foreign exchange cur$e out to the right. )ue to the change in tastes and preferences, and its resulting effect on the demand for foreign exchange, the domestic economy would run a balance of payments deficit &i.e. in this example, the domestic economy would import more foreign goods than it exports. Therefore the domestic economy would ha$e a merchandise trade deficit and, ceteris paribus, a balance of payments deficit. The foreign economy would ha$e a balance of payments surplus since, ceteris paribus, the increase in demand for its goods causes that country to export more, causing a surplus in merchandise trade and hence a balance of payments surplus'. )ue to the increase in demand for foreign exchange, the exchange rate rises until the demand for foreign exchange e*uals the supply of foreign exchange. "t such a point, the balance of payments would restore back to e*uilibrium. +ow, " rise in the exchange rate makes the imports to a domestic economy more expensi$e and their exports more attracti$e &exactly what is needed to correct the balance of payments deficit-.export more, import less'. /rom the perspecti$e of the foreign economy, a rising exchange rate implies that their currency has appreciated. This makes their exports unattracti$e and they will want to import more foreign goods since it is cheaper for them to do so. (onse*uently, the foreign economy will import the domestic economys exports. This will cause their merchandise trade balance to shrink from one of a surplus to that of e*uilibrium. The two adjustments-a decrease in domestic imports from the foreign country, and an increase in domestic exports to the foreign country-are exactly what is needed to correct the balance of payments deficit. Disadvantages of flexible exchange rates Uncertainty and diminished trade! #f an indi$idual in a domestic economy contracts to buy the exports of another country, a sudden fall in the exchange rate &i.e. depreciation of the domestic currency' will increase the price of the goods being imported to the domestic economy. (eteris paribus, this may result in substantial losses. Because of such a risk, the domestic importer may want to confine his0her purchases to strict domestic goods and ser$ices, thereby reducing international trade. Terms of trade changes! " nations terms of trade will be worsen by a decline in the international $alue of its currency. /or example, an increase in the domestic price of foreign exchange &i.e. a depreciation of the domestic currency in terms of the other country' will mean that the domestic country will ha$e to export more goods and ser$ices to be able to finance a gi$en le$el of imports. Instability! /lexible exchange rates may ha$e destabilizing effects on the domestic economy because wide fluctuations stimulate then contract industries producing exported goods. /oe example, if a domestic economy is at full employment &i.e. it is on its %%(', a depreciation in its currency will ha$e an inflationary effect since foreign demand for domestic goods &i.e. domestic exports' rises. Fixed exchange rates and the balance of payments #n the example abo$e, what would be the effects to a domestic economy from an increase in tastes and preferences for foreign goods, The domestic increase in demand for foreign goods increases the demand for foreign currency &domestic balance of payments deficit'. 1nder flexible exchange rates, the exchange rate would rise and restore e*uilibrium in either countrys balance of payments. Because the exchange rate is fixed, the domestic go$ernment must inter$ene by supplying more foreign exchange to the foreign exchange market. The supply of foreign exchange in the market increase until the demand for and supply of foreign exchange results in no change in the exchange rate. The problem with this is that a countrys central bank has a limited supply of foreign exchange &i.e. it cannot continue to supply foreign exchange to the foreign exchange market to peg the exchange rate'. 2$entually, a country may be forced to abandon a fixed exchange rate.