The balance of payments records transactions between residents of one country and the rest of the world. The current account shows the trade balance plus net international transfer payments, and income earned on holdings of foreign assets. The financial account shows net purchases and sales of foreign assets. The balance of payments is the sum of the current and financial account balances.
The trade in goods and services recorded in the current account is net exports, based on tastes, incomes, and the real exchange rate, which measures the price of foreign goods and services relative to the price of domestic goods and services.
The trade in financial assets recorded in the financial account is based on the total return expected from holding foreign rather than domestic assets.
The total return on holdings of foreign assets depends on the interest rate differential between countries and the change in the exchange rate during the period in which assets are held. Perfect international capital mobility means that an enormous quantity of funds shifts between currencies when the perceived rate of return differs across currencies.
The foreign exchange market is the market in which currencies of different countries are bought and sold and foreign exchange rates are established. The exchange rate is the price at which one currency trades for another.
The demand for foreign currency on the foreign exchange market arises from imports of goods and services and purchases of foreign assets. The supply of foreign currency on the foreign exchange market arises from exports of goods and services and sales of domestic assets to foreigners.
Under a fixed exchange rate regime, a balance of payments surplus or deficit must be matched by an offsetting quantity of official financing. The central bank intervenes in the foreign exchange market.
Under floating or flexible exchange rates, supply and demand in the foreign exchange market change the exchange rate as necessary for a current account balance that offsets a capital account balance. As a result, the balance of payments is zero and no official intervention is involved.
The choice between fixed and floating exchange rate regimes reflects a country's assessment of the importance of an independent monetary policy, the volatility of exports and imports, and the financial discipline that may come with fixed rates.
Flexible exchange rates increase the effectiveness of monetary policy as a tool to manage aggregate demand. The effectiveness of fiscal policy for demand management is reduced, but pursuit of deficit and debt ratio control may be enhanced.
Monetary policy sovereignty is lost when fixed exchange rates are adopted. Monetary policy cannot effectively pursue domestic inflation or output targets. However, the effectiveness of fiscal policy as a demand management tool is enhanced.