Internal and external balance under fixed exchange...

Internal and external balance under fixed exchange rates

A situation of fixed exchange rates and unemployment is depicted in Figure 3.4.The economy is assumed to be at point A with interest rate r1 and income level Y1, which means that while the economy is in external balance the income level is below the full employment level of income Yf.

The government attempts to eradicate the unemployment via a bond-financed fiscal expansion; this shifts the IS schedule to the right from IS1 to IS2.Domestic output expands from Y1 to Y2 and the economy would be at point B with interest rate r2.In raising the level of output beyond the full employment level we find that the induced increase in imports moves the current account into deficit, and although the rise in the interest rate attracts some capital inflow the balance of payments is in overall deficit since the economy is to the right of the BP schedule.The authorities are forced to purchase the home currency in the foreign exchange market, but because they pursue a sterilization policy the LM schedule remains at LM1.Hence, using only a single policy instrument, in this case fiscal policy, the government can temporarily achieve its internal objective at the expense of a sacrifice in the objective of external balance.

Ideally, however, the authorities would like to achieve both internal and external balance.This is possible if they combine the expansionary fiscal policy—IS1 to IS2—with a contractionary monetary policy which shifts the LM schedule from LM1 to LM2 where it passes through point C on the BP schedule.The restrictive monetary policy raises interest rates further than in the case of a solely fiscal expansion to r3, and in so doing attracts additional capital inflows so as to restore the balance of payments back to equilibrium.Hence, by combining an expansionary fiscal policy with a contractionary monetary policy the authorities can achieve both internal and external balance.An important lesson from this example is that both internal and external balance can be achieved without the need to change the exchange rate; this is because the authorities have two independent instruments available, monetary and fiscal policy and two targets.