ABSTRACT
To maintain external equilibrium under a system of floating exchange rates, in which official intervention is absent, the exchange rate must always adjust. The economy must therefore always adjust to a position along the external equilibrium (EE) curve. This resolves the problem of policy assignments which arises under fixed exchange rates and means that monetary and fiscal stabilisation policies can be applied directly to the attainment of internal equilibrium. Floating exchange rates are better able to insulate the economy against product market shocks than fixed exchange rates which, in turn, are better able to insulate the economy against money market disturbances. Perfect capital mobility applies equally to both floating and fixed exchange rates. The EE curve, which represents a perfectly elastic supply of international capital, becomes horizontal at prevailing international interest rates and shifts only when these or exchange rate expectations change.
