Implications of fixed and flexible exchange rate regimes

Question

Explain “balance of payments” identity and discuss some of its implications under the fixed and flexible exchange rate regimes.

Answer 1

Balance of payments identity states that the joint balance on the current and capital accounts must be same as its size, however opposite in the sign, to the change in the official reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, the central banks never engage in the official reserve transactions. Hence, overall balance should balance, i.e., BCA = -BKA. Under fixed exchange rate regime, though, a country may have overall BOP surplus or deficit as central bank can accommodate it via the official reserve transactions.