Distinguish between internal and External Balance.

Various countries face policy dilemma in terms of their internal and external balance. The internal balance refers to output at full employment level whereas the external balance refers to balance of payments equal to zero.

The balance of payment is equal to 0 due to the assumption of perfect capital mobility. This dilemma sometimes happens due to clashes between the internal and external balance goals of the country.

The vertical line mm’ shows the amount of imports that in the short-run gives external balance. The two aims (internal and external balance) of the economy are jointly and simultaneously fulfilled at the point P in the Fig. 51.1 where the two lines intersect. Corresponding to these two aims are the two policy measures—monetary plus fiscal policy, on the one hand, and variations in the exchange rate, on the other.

If an economy is at the point where there is under-employment and deficit in balance of payments then an expansionary monetary policy would result into policy dilemma since the policy will help in increasing employment but at the same time would worsen the balance of payment deficit. This is because expansionary monetary policy shifts LM curve downwards resulting into an increase in income but a decline in the rate of interest. Thus, the policy even though would help in maintaining the internal balance but would not achieve the external balance.

However, an expansionary fiscal policy shifts IS curve upwards resulting into increase in both the output and the rate of interest thus moving the economy more towards the point E. Therefore, depending upon where the economy is in the four quadrants of figure , a mix of both monetary and fiscal policies would be required to achieve both internal and external balance of the economy but that would again depend upon the regime of exchange rate prevailing in the economy.

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