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Policies for Internal and External Balance
A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality. Expenditure-reducing policies aim at reducing aggregate demand through higher taxes and interest rates thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic goods. Consequently, the country's imports are reduced. Expenditure-switching policies aim at increasing the demand for domestic goods and to change expenditure from imported goods to domestic goods. Such expenditure-switching increases domestic output. So long as the marginal propensity to spend is less than unity, it will improve the country's balance of payments.
To achieve both objectives of internal and external balance simultaneously a judicious combination of expenditure-reducing and expenditure-switching instruments is needed. For instance, if the economy is already at the full employment level, a policy of devaluation may cause inflation within the economy. So expenditure-switching policy of devaluation must be accompanied by expenditure-policies of tighter fiscal and monetary controls to maintain full employment and balance of payments equilibrium.
In order to explain this type of policy measures which may be required to achieve internal and external balance simultaneously, we take eight possible cases of disequilibrium in Figure 5.3. These cases require different combinations of policy measures. A country at point A has equilibrium in the balance of payments and
unemployment (or recession). Such a situation requires expansion of the domestic economy through increase in domestic expenditure: This will reduce net exports.
In order to counteract this tendency, devaluation should be combined with increase in domestic expenditure. If unemployment and a deficit in the balance of payment exit simultaneously, as at point K in zone ill, there should be increase in domestic expenditure. A policy that raises internal demand through expansionary measures also increases domestic employment-But this policy widens the deficit in the balance of payments. This is described as the "dilemma zone", because instead of an expansionary policy, devaluation is the preferable policy. If the economy combines full employment with a deficit in the balance of payments, as at point D, devaluation is the remedy. This will create a large export surplus and excess foreign demand will lead to inflation in the domestic economy. To counteract these tendencies, a smaller devaluation will have to be combined with a cut in domestic expenditure. Take point tf in Zone IV where domestic inflation is combined with a deficit in the balance of payments. Inflation should be combated with reduction in domestic expenditure which would also reduce the deficit in the balance of payments and ultimately move the economy towards the equilibrium position E. If the country has balance of payments equilibrium and inflation as at point f; it should appreciate its exchange rate and reduce domestic expenditure.
Take point G in Zone I where a surplus in the balance of payments is combined with inflation. In this situation, the exchange rate should be appreciated to correct the surplus and expenditure be reduced to combat inflation. But reduction in expenditure would increase the surplus. This again represents the "dilemma zone". If the country has full employment and a surplus in the balance of payments, as at point C, it should appreciate its exchange rate. But appreciation would create
unemployment. To avoid it, it should increase domestic expenditure.
Finally, move to point F in Zone n where a surplus in the balance of payments is combined with unemployment. Here the increase in domestic expenditure would be appropriate for both internal and external balances. Such a policy will raise
employment and also induce an increase in imports to reduce the size of the surplus.
The above discussion reveals that if the economy is on neither the FF (internal balance) curve nor the XX (external balance) curve, it is in one of the four zones. When the economy follows only one policy or both expenditure-switching and domestic expenditure policies simultaneously to achieve one target (say, internal balance), it moves away from the other target (say, external balance). This problem arises not only in the "dilemma zones" I and HI, but also in the "simple zones" II and IV. For instance, if we take point F in Zone H where a surplus in the balance of payments is combined
with unemployment an expansionary policy will reduce unemployment and reduce the surplus. But to move the economy to full equilibrium point F, appreciation or depreciation of the exchange rate will have to be adopted which will move the economy away from one target or the other.
Mundell discusses the case of relationship between two tools and two objectives. The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure. The two objectives are full employment (internal balance) and balance of payments equilibrium (external balance).
A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality. Expenditure-reducing policies aim at reducing aggregate demand through higher taxes and interest rates thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic goods. Consequently, the country's imports are reduced. Expenditure-switching policies aim at increasing the demand for domestic goods and to change expenditure from imported goods to domestic goods. Such expenditure-switching increases domestic output. So long as the marginal propensity to spend is less than unity, it will improve the country's balance of payments.
To achieve both objectives of internal and external balance simultaneously a judicious combination of expenditure-reducing and expenditure-switching instruments is needed. For instance, if the economy is already at the full employment level, a policy of devaluation may cause inflation within the economy. So expenditure-switching policy of devaluation must be accompanied by expenditure-policies of tighter fiscal and monetary controls to maintain full employment and balance of payments equilibrium.
In order to explain this type of policy measures which may be required to achieve internal and external balance simultaneously, we take eight possible cases of disequilibrium in Figure 5.3. These cases require different combinations of policy measures. A country at point A has equilibrium in the balance of payments and
unemployment (or recession). Such a situation requires expansion of the domestic economy through increase in domestic expenditure: This will reduce net exports.
In order to counteract this tendency, devaluation should be combined with increase in domestic expenditure. If unemployment and a deficit in the balance of payment exit simultaneously, as at point K in zone ill, there should be increase in domestic expenditure. A policy that raises internal demand through expansionary measures also increases domestic employment-But this policy widens the deficit in the balance of payments. This is described as the "dilemma zone", because instead of an expansionary policy, devaluation is the preferable policy. If the economy combines full employment with a deficit in the balance of payments, as at point D, devaluation is the remedy. This will create a large export surplus and excess foreign demand will lead to inflation in the domestic economy. To counteract these tendencies, a smaller devaluation will have to be combined with a cut in domestic expenditure. Take point tf in Zone IV where domestic inflation is combined with a deficit in the balance of payments. Inflation should be combated with reduction in domestic expenditure which would also reduce the deficit in the balance of payments and ultimately move the economy towards the equilibrium position E. If the country has balance of payments equilibrium and inflation as at point f; it should appreciate its exchange rate and reduce domestic expenditure.
unemployment. To avoid it, it should increase domestic expenditure.
Finally, move to point F in Zone n where a surplus in the balance of payments is combined with unemployment. Here the increase in domestic expenditure would be appropriate for both internal and external balances. Such a policy will raise
employment and also induce an increase in imports to reduce the size of the surplus.
The above discussion reveals that if the economy is on neither the FF (internal balance) curve nor the XX (external balance) curve, it is in one of the four zones. When the economy follows only one policy or both expenditure-switching and domestic expenditure policies simultaneously to achieve one target (say, internal balance), it moves away from the other target (say, external balance). This problem arises not only in the "dilemma zones" I and HI, but also in the "simple zones" II and IV. For instance, if we take point F in Zone H where a surplus in the balance of payments is combined
with unemployment an expansionary policy will reduce unemployment and reduce the surplus. But to move the economy to full equilibrium point F, appreciation or depreciation of the exchange rate will have to be adopted which will move the economy away from one target or the other.
Mundell discusses the case of relationship between two tools and two objectives. The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure. The two objectives are full employment (internal balance) and balance of payments equilibrium (external balance).
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