"To achieve both internal and external balance the authorities must use both expenditure switching and expenditure changing policies." Discuss

Andrew Gill International Economics

“To achieve both internal and external balance the authorities must use both expenditure switching and expenditure changing policies.” Discuss.

Internal and external balances are two of the most important economic goals or objectives for a country. (The others include a reasonable rate of growth, an equitable distribution of income and, adequate protection of the environment).

Internal balance “ refers to full employment or rates of unemployment no more than 4 – 5 per cent” (Salvatore). The 4 – 5 per cent allows for frictional unemployment, that is the transition period between changing jobs and allows for re-training for workers.

External balance refers to equilibrium in the balance of payments – “ or a desired temporary disequilibrium such as a surplus that a nation may want in order to replenish its depleted international reserves”. (SALVATORE)

Most nations will prioritise internal balance rather than external balance, however in certain circumstances they may be forced to switch their priorities. In particular when presented with the problem of large external imbalances.

At each countries disposal are two policies to rectify any imbalances either internal or external; they are expenditure - changing policies and expenditure – switching policies.

Expenditure – changing policies revolve around fiscal and monetary policies. Fiscal policy refers to changes in government spending and or taxes. There are two types of fiscal policy expansionary and contractionary. Expansionary fiscal policy occurs when government spending is increased and /or taxes are reduced. The effect of this is an expansion of domestic production and income based on a multiplier process. An expansionary fiscal policy also induces an increase in imports; the extent of this increase is largely dependent on the nations marginal propensity to import.

Contractionary fiscal policy is a product of reduced government spending and/or an increase in taxes, reducing both ...

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Contractionary fiscal policy is a product of reduced government spending and/or an increase in taxes, reducing both domestic production and income while inducing a fall in imports.

Monetary policy revolves around a nations money supply that affects domestic interest rates. In the same way that there are two types of fiscal policy (expansionary and contractionary) there are also two types of monetary policy; easy and tight. An easy monetary policy results in interest rates being dropped and is accomplished by increasing the money supply. Thus encouraging an increase In investment and income in the nation while also inducing a rise in imports.

A tight monetary policy is simply the opposite of an easy monetary policy. By reducing the money supply the authorities can raise the domestic interest rate for the country (less money in an economy means that money in a sense is more expensive resulting in higher interest rats). This discourages investment, income and imports and can also lead to short-term capital inflow or reduced outflow.

Expenditure-switching policies refers to changes in the exchange rate, but more precisely the devaluation or revaluation of the countries currency. A devaluation switches expenditure away from foreign commodities and towards domestic commodities. This is because to the average person devaluation in currency means that foreign goods have become more expensive and therefore they will revert back to domestic goods. A devaluation can therefore be extremely useful for authorities when there is a deficit in a countries balance of payments. However part of the original improvement is neutralised as a devaluation also increases domestic production and therefore also imports. (Balance of payments can be defined as “a summary statement of all international transactions of the residents of a nation with the rest of the world over the course of a year”) (D.Salvatore, (2001), 7thEd. International Economics)

A revaluation switches expenditure from domestic to foreign products and thus can help to correct a balance of payments surplus. However yet again part of the revaluation effect is neutralised as domestic production is reduced and consequently, induces a decline in imports.

I will now demonstrate, with the aid of the Swan diagram, how internal and external balance can only be achieved using expenditure shifting and expenditure changing policies simultaneously, with the exception of one or two very unusual cases.

We must also now establish two assumptions. They are:

A zero international capital flow (so that the balance of payments is equal to the nation’s trade balance)
That prices remain constant until aggregate demand begins to exceed the full employment level of output.

SWAN DIAGRAM

The vertical axis measures the exchange rate R while the horizontal axis displays domestic expenditures or absorption D (the effect of induced income changes in the process of correcting a balance-of-payments disequilibrium by a change in the exchange rate. An increase on the R suggests devaluation while a decrease in R means a revaluation of the currency. Domestic expenditures and absorption displayed on the horizontal also represents government spending along with domestic consumption and investments. This is important to understand as governments can manipulate how much they spend in the pursuit of fiscal policy.

The EE curve, which is positively sloped, refers to external balance and shows the various combinations of exchange rates and real domestic expenditures/absorption. The curve EE must be positively sloped, as an increase in R would result in an improvement of a nation’s trade balance and thus must be matched by an increase in D in order to induce an increase in imports to keep maintain external balance but also to keep the trade balance in equilibrium. The diagram above depicts this very clearly. For external balance to remain after an increase in R from R2 to R3 it must be followed by an increase in D from D2 to D3 which can be seen as point J on curve EE. The consequence of smaller or larger increase in D would be either a balance of trade surplus or a balance of trade deficit respectively.