Windows XP Mode provides seamless integration of the VM (guest) with the Windows 7 host desktop, by means of Integration Components (ICs). You can run Windows XP Mode as a full Windows XP desktop in two different ways:

Enhanced Mode is the default in which XP Mode VM starts. Majority of users prefer this, as it’s easy to use and provides the complete set of integration features described above. For e.g., saved credentials feature is provided in Enhanced Mode, so that users don’t have to login each time they launch Windows XP Mode.
Basic Mode provides basic integration features such as mouse and keyboard integration, USB support, time sync and heartbeat parity between the VM and the host. Integration features such as clipboard sharing, drive sharing and printer redirection are not available in this mode.
Virtual Applications Mode is the third mode – a completely seamless solution to application compatibility. This is the most likely and preferable way to launch and run your virtual applications, as they’re seamlessly integrated with Windows 7 desktop and Start menu. When an application is installed in the Windows XP Mode VM, a shortcut is automatically published to the Start menu of Windows 7, as explained in the previous blog.

Full Article: Windows Virtual PC