Internal and External Equilibrium: Problems of Economic Policy
The dilemma of economic policy in an open economy: internal and external equilibrium. In an open economy, the goal of macroeconomic policy should be the simultaneous achievement of both internal and external equilibrium. Under internal equilibrium is usually understood as the "full employment" state, or the equality of aggregate demand and aggregate supply at the level of potential output, with a minimum allowable level of inflation. In the short term, the problem of internal equilibrium is solved primarily by methods of regulating aggregate demand through fiscal and monetary policy. External equilibrium can mean maintaining a balanced balance of payments formal payments, zero (or a given target) balance of current operations, a certain level of foreign exchange reserves. In order to achieve the set goals in an open economy, along with traditional types of macroeconomic policies, such as fiscal and monetary policy, foreign trade, foreign exchange and foreign debt management can be used.
In fact, the maintenance of external and internal equilibrium concerns the functioning of the commodity, money and foreign markets. The problem is that some fiscal and monetary measures that have proved to be effective in the closed economy are often ineffective in an open economy.
Fiscal policy affects the balance of payments in two ways: through changes in income and interest rates.
Effect of capital mobility on the effectiveness of fiscal and monetary policy. The Mundell-Fleming model. The IS - LM-VR model is built for different exchange rate regimes, as well as varying degrees of mobility of capital. A small open economy with perfect capital mobility can be analyzed using the Mundell-Fleming model.
The ratio between internal ( YY ) and external ( BP ) is determined by the influence budgetary ( G - public spending) and monetary ( r - the interest rate level) policy (Fig. 10.13).
Moving to the right on the horizontal axis means expansionary budgetary policies - increasing government spending and (or) reducing taxes. Move left -
Fig. 10.13. The Mundell-Fleming diagram
restrictive fiscal policies - reducing costs and (or) increasing taxes. The upward movement along the vertical axis is a tight monetary policy (growth of the interest rate and compression of the money supply), down the vertical axis - a soft monetary policy (money supply growth and interest rate reduction).
The curve YY shows a combination of fiscal and monetary policies that lead to an internal balance - a level of domestic production that provides full employment and a sustained low inflation rate. It has a positive slope, because to maintain the internal balance, the expansionary fiscal policy shifting the curve to the right into the zone of excessive demand (from the point E to the point A ), where increased income creates inflationary pressures, must be compensated by tight monetary policy aimed at reducing the money supply by raising the interest rate. As a result, revenue returns to the level at full utilization of resources and internal equilibrium is restored (movement from A to D ). Thus, all the points on the right and below the YY curve are in the zone of excessive demand due to the growth of government spending or the reduction in the cost of money. The points on the left and above the YY curve are in the redundant supply zone provided by the contraction G and an increase in the price of money - r.
The positive slope of the BP curve is due to the fact that when public spending increases (from Е to А ) increase incomes, imports increase, which provokes a deficit of trade and, accordingly, balance of payments. To eliminate the shortage, the government should take measures to reduce it due to the positive balance of capital flows. This can be achieved by raising the interest rate (moving from A to C ) and attracting foreign capital to the country. It is this combination of changes in government spending and the interest rate, ensuring the preservation of external equilibrium, that determines the positive slope of the BP curve.
All the points below (a decrease in the interest rate, a deficit in the capital account) and to the right (the increase in public spending, the current account deficit) curve BP, reflect the state of the deficit balance of payments ( BP 0). Any point to the left of and above the curve BP reflects the balance of payments surplus ( BP & gt; 0).The steepness of the external equilibrium curve depends on the degree of capital mobility: the more capital is mobilized, the smaller the increase in the interest rate will ensure its greater inflow that will be required to finance the balance of payments deficit . Therefore, the curve will be more shallow, and vice versa.
Determining the impact of fiscal and monetary (monetary) policies on internal and external balances, R. Mundell and M. Fleming found that monetary and fiscal policies have different relative effects on internal and external equilibrium. They showed that with a fixed exchange rate, monetary policy has the advantage in regulating external equilibrium, and fiscal policy has an advantage in regulating internal equilibrium.
If the country faces the central bank's task of managing the exchange rate in order to maintain its stability, it will solve this problem through currency interventions and, accordingly, changes in the money supply, regardless of which internal goals (anti-inflation or anti-crisis) are recognized as priority. To neutralize the impact of the balance of payments on the supply of money, the central bank can expand domestic assets through open market operations (selling government debt and raising funds into reserves).
In Fig. 10.13 the advantages of monetary policy in the area of regulation of the external balance are illustrated by the fact that in order to maintain an external equilibrium (moving from the point E to the point C ) requires a smaller change in the interest rate than to maintain internal equilibrium (from E to D ). Conversely, fiscal policy will have a stronger impact on the internal balance. If the economy is at K, , then a small change in government spending G will be required to restore internal equilibrium (moving from To in M ), whereas for the restoration of external equilibrium, a larger change in government spending (moving from < strong> To in From ).
In Fig. 10.13, there are four types of imbalances in which an economy can be located:
Sector I - balance of payments deficit + excess demand (inflation);
Sector II - balance of payments deficit + excess supply (unemployment)
Sector III - balance of payments surplus + excess supply (unemployment)
Sector IV - surplus of the balance of payments + excess demand (inflation).
Based on the combination of external and internal imbalances, there is a choice of directions and tools for macroeconomic policy. If the situation in the economy is characterized by the situation in sector I, then in order to achieve general equilibrium, it is necessary to combine a reduction in government spending (to overcome inflation) and an increase in the interest rate (for equalizing the balance of payments). The situation of the economy in sector III will require opposite measures. In sector II, the balance of payments deficit and unemployment always require fiscal expansion combined with tight monetary policy. The level of the interest rate and government spending is always below what is necessary for equilibrium. In sector IV, everything is the opposite.
The choice of directions and instruments of macroeconomic policy is determined by the list of authorities of the relevant state authorities.
Using different types of macroeconomic policies to achieve the goals of economic development. Rule of distribution of roles. The main bodies that carry out macroeconomic policies are the central bank and the ministry of finance, between which the appropriate authority is allocated (Table 10.10).
Distribution of powers between public authorities
Ministry of Finance
Ensures external balance
Ensures internal balance
Uses monetary instruments: the money supply M and the interest rate d
Uses fiscal tools: taxes T and government spending G
With a positive balance of payments ( BP & gt; 0), the interest rate decreases ( r ↓)
With increasing unemployment, public spending increases (G ↑)
With a negative balance of payments ( BP 0), the interest rate rises ( r ↑)
With rising inflation, public spending is declining (G ↓)
Correct assignment of powers allows to provide the aggregate (internal and external) balance (Figure 10.14).
Fig. 10.14. Role distribution rule action
It can be seen from the figure that if the economy is in a situation with a deficit in the balance of payments and a high level of inflation (point L), the central bank begins to raise the interest rate, providing an external equilibrium (movement from A in C ). At the same time, seeking an internal balance, the Ministry of Finance, acting on inflation, reduces public spending (movement from C to M ). As a consequence, there is an external imbalance with the positive balance of payments, which causes the central bank to lower the interest rate (movement from M to N ). The lowering of the interest rate revives inflation, the Ministry of Finance begins to cut government spending (the move from N to To ). Then the actions will be repeated until the general external and internal equilibrium is established in the market.
The rule for the distribution of roles is the solution of a particular task by that body whose tools have a relatively greater influence on its solution.
At a fixed exchange rate, maintaining the external balance is provided by monetary policy tools, and maintaining internal equilibrium - instruments of fiscal policy.
Any other distribution of powers leads to a negative result, which is to move away from the equilibrium situation, increasing the amplitude of inflation and balance of payments deficit.
In any case, the implementation of an effective macroeconomic policy at the present time is impossible without taking into account the processes of globalization of the world economy.
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