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Chapter 25. The main challenges for macroeconomic theory are to explain the long-term economic growth and the short-term business fluctuations observed in the real world. This book offers an introduction to advanced economic analysis of these issues and seeks to bridge the gap between the typical intermediate macroeconomics text and the more advanced texts used at the graduate level. Each chapter ends with an extended summary highlighting the main points to be learned and is followed by a number of exercises intended to deepen the student''s understanding of the material covered. Chapter 25: As we have seen, a fixed exchange rate regime is vulnerable to speculative attacks in a world with high capital mobility. In recent years many governments have learned this lesson the hard way. The present chapter studies the workings of an open economy with flexible exchange rates. We continue to focus on a small specialized economy, and in line with the previous chapter we assume perfect capital mobility, since significant capital controls are nowadays very rare among developed countries. The first section of the chapter defines the characteristics of a flexible exchange rate regime and describes how a number of Western countries have designed their monetary policies under this regime. This part of the chapter also highlights the role of exchange rate expectations under flexible exchange rates. In the second section we adapt our AS-AD model to a regime with flexible exchange rates and identify the similarities and differences in the macroeconomic adjustment process under flexible and fixed exchange rates. The third and final section of the chapter then studies how an open economy with flexible exchange rates reacts to demand and supply shocks and compares these reactions to those occurring under fixed exchange rates.