Under a fixed exchange rate system, the government does not allow the forces of supply and demand to determine the exchange rate. Instead, the government fixes the exchange rate at what it believes is the “right” rate, and the central bank, armed with a stockpile of foreign exchange reserves, stands ready to buy or sell foreign currency at that rate. If there is a balance of payments surplus, the demand for our dollar by foreigners is greater than the supply, so some of these foreigners will seek extra, unavailable dollars. Under a flexible exchange rate, they would have to get dollars by offering more foreign exchange, but under a fixed exchange rate this higher cost can be avoided because the Fed will exchange their foreign currency for dollars at the fixed rate. When the Fed does so, it takes the extra foreign exchange (currency) and in return provides dollars. The most important implication of this process is that the domestic money supply increases by the increase in dollars times the money multiplier.

When there is a balance of payments deficit, the opposite occurs. We are supplying more dollars on the foreign exchange market (seeking foreign currency to take vacations abroad, for example) than there is foreign demand for dollars, so those of us unable to obtain foreign currency from foreigners go to the Fed to buy foreign exchange at the fixed rate. To buy the foreign currency we give the Fed dollars, removing them from public circulation and thereby decreasing the domestic money supply.

To summarize, if the economy has a fixed exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the money supply to change, in turn affecting economic activity.

Armed with these two general results—that international imbalance causes exchange-rate changes under a flexible exchange rate system and money-supply changes under a fixed exchange rate system—we can examine how monetary and fiscal policy are affected by repercussions from the international sector. To maintain simplicity, all analysis ignores price-level changes and inflation. Incorporating them would not change the general results, only the breakdown of nominal income changes into real changes and price changes.