Describe the balance of payments identity and discuss its implications under the fixed and flexible exchange rate regimes.
When the balance-of-payments accounts are recorded correctly, the balance of payments identity is BCA (balance on the current account) + BKA (balance on the capital account) +BRA (balance on the reserves account) = 0. The equation indicates that a country can run a balance-of-payments surplus or deficit by increasing or decreasing its official reserves. Under the fixed exchange rate regime, countries maintain official reserves that allow them to have balance-of-payments disequilibrium, that is where BCA + BKA does not equal 0, without adjusting the exchange rate. Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the office reserves (BCA + BKA = -BRA). For example, if a country runs a deficit on the overall balance, that is, BCA + BKA is negative, the central bank of the country can supply foreign exchanges out of its reserve holdings. But if the deficit persists, the central bank will eventually run out of its reserves, and the country may be forced to devaluate its currency.