Policies for Internal and External Balance

The theory of economic policy has concentrated on two distinct problems. First, the relation between the number of policy objectives and the number of policy instruments; and second, the assignment of policy instruments to the realisation of targets.

Jan Tinbergen was the first economist to lay down that the number of policy instruments must be equal to the number of objectives. If there are more objectives than policy instruments it means that there are not enough tools to achieve the policy objectives. The system is undetermined.

On the other hand, if the number of policy instruments are more than the number of objectives, then there is not one combination of tools and objectives that will solve the problem, but any number. The system is over-determined. Thus the number of policy tools must equal the number of targets for economic policy to be successful. This has come to be known as the Tinbergen Principle or the fixed targets approach.

In order to achieve given objectives with the same number of policy instruments, the second problem of the assignment of instruments to targets arises. The formulation of the assignment problem will eventually lead to equilibrium values of the objectives, despite lack of coordination between them.

Conflicts between Internal and External Balance:

Meade was the first economist to discuss the potential conflicts between policies for internal and external balance with only one policy instrument, financial or demand management, and with repercussions on a trading partner country. If there are two countries A and B, deflation of domestic expenditure in A will reduce employment and income in A.

This will reduce A’s imports which will improve its balance of payments. Since B’s exports are reduced, B’s income and employment will fall and make its balance of payments unfavourable. If B does not adopt any policy measure, A faces no policy conflict because if it expands its demand, it will raise employment and income in A and reduce its surplus balance of payments. But if A does nothing, B faces a policy conflict.

If B adopts a policy of increasing its domestic expenditure to overcome internal depression, and a policy of deflation of domestic expenditure to restrict the demand for imports in B, there is a sharp conflict of policy. It is inflationary policy to stabilise employment and income, and deflationary policy to bring balance of payments equilibrium. Meade examines all possible types of disequilibrium in the two countries and shows that when each country adopts a policy which requires action in the same direction for both internal and external balance, very few conflicting situations arise. But if one or the other country does not take appropriate policy action in the same direction, the numbers of conflicting situations increase.

When there are conflicts between two goals, two instruments are required, instead of one, which are discussed as under.

Policies for Internal and External Balance:

It was Johnson who pointed towards the range of policy instruments for bringing about both internal and external balance. He called them expenditure-reducing or internal policies, and expenditure-switching or external policies.

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-reducing policies of tighter fiscal and monetary controls to maintain full employment and balance of payments equilibrium.

In order to attain simultaneously the two targets of internal and external balance, the relationship between policy instruments are discussed in terms of Trevor Swan’s model explained in Fig. 1.

The Swan Model:

Swan explains the appropriate combinations of expenditure-switching and expenditure-reducing policies to attain internal and external balance.

Assumptions:

The model is based on the assumptions that:

(1) There are no trade restrictions;

(2) There are no capital movements; and

(3) Productivity, terms of trade and other financial transfers are given.

In Fig. 1 the horizontal axis measures real domestic expenditure, and the vertical axis measures the cost ratio which is an index of relative costs measuring the competitiveness of the economy. A movement to the left (towards O) on the horizontal axis means the use of expenditure-reducing policy, and a movement upwards along the vertical axis means the use of expenditure-switching policy. FF is the internal balance curve which represents a situation of full employment.

It represents the various combinations of cost ratio and real domestic expenditure. A given level of employment can be achieved by either a highly favourable cost ratio and a relatively low level of domestic expenditure or by a less favourable cost ratio and a relatively higher level of expenditure. Thus the FF curve slopes downward to the right. Obviously, points to the right (above) the FF curve relate to inflation or over full employment, and points to the left (below) of the curve refer to recession or unemployment.

The XX curve represents the external balance where exports equal imports, in the absence of capital movements. So external balance occurs when net exports equal zero. This curve slopes upwards from left to right which shows that for the economy to remain in external balance, devaluation must be balanced by an increase in domestic expenditure. (Devaluation will improve the country’s trade balance by encouraging exports and discouraging imports, and the increase in real domestic expenditure will increase the country’s imports sufficiently.) Obviously, points above the XX curve refer to a surplus and points below the curve relate to a deficit in the balance of payments.

The point where the FF curve intersects the XX curve represents the point of “bliss”, where the economy is simultaneously in internal and external balance. E is such a point in Fig. 1 where the exchange rate and real domestic expenditure are in equilibrium. If the economy is not at point E, it is in disequilibrium. According to Swan, “The two curves of internal balance and external balance divide existence into four zones of economic unhappiness.”

The four zones of disequilibrium are:

Zone I: Inflation and balance of payments surplus

Zone II : Unemployment and balance of payments surplus.

Zone III: Unemployment and balance of payments deficit.

Zone IV: Inflation and balance of payments deficit.

Policy Measures:

In order to explain the type of policy measures which may be required to achieve internal and external balance simultaneously, we take eight possible cases of disequilibrium in Fig. 2. 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 exist simultaneously, as at point K in zone III, 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 H 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 B, 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 II where a surplus in the balance of payments is combined with unemployment. Here 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, interned balance), it moves away from the other target (say, external balance).

This problem arises not only in the “dilemma zones” I and III but also in the “simple zones” II and IV. For instance, if we take point F in Zone II 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 E, appreciation or depreciation of the exchange rate will have to be adopted which will move the economy away from one target or the other.