a - Internal and external balance framework

Overview

The Internal–External Balance Framework is a graphical model used to analyze how governments can simultaneously achieve:

• Internal Balance: full employment with price stability.
• External Balance: a current account consistent with long-run sustainability.

The framework combines two policy instruments:

• Domestic spending (A), mainly influenced by fiscal policy.
• Exchange rate (E), influenced by exchange-rate policy (or, under floating rates, indirectly by monetary policy).

Although introduced in the discussion of the Bretton Woods System, the framework applies to both fixed and floating exchange rate regimes.

Definition

The model represents the combinations of:

• exchange rate (E)
• domestic spending (A)

that achieve:

• internal balance (II schedule);
• external balance (XX schedule).

The intersection of the two schedules represents the unique policy combination that simultaneously satisfies both objectives.

Variables

Exchange Rate (E)

The vertical axis measures

E = domestic currency price of foreign currency

An increase in E means:

• currency depreciation;
• domestic goods become relatively cheaper;
• exports increase;
• imports decrease.

Domestic Spending (A)

The horizontal axis measures domestic absorption.

\[A=C+I+G\]

where

• C = Consumption
• I = Investment
• G = Government spending

Higher domestic spending increases aggregate demand but also increases imports.

Internal Balance (II)

Definition

Internal balance exists when output equals full-employment output.

\[Y=Y^F\]

Aggregate demand is

\[Y=A+CA\left(\frac{EP^*}{P},A\right)\]

Internal balance therefore requires

\[Y^F=A+CA\left(\frac{EP^*}{P},A\right)\]

Economic Intuition

Both variables increase aggregate demand:

• higher domestic spending increases demand directly;
• depreciation increases exports.

Since both stimulate output:

• if the exchange rate depreciates,
• domestic spending must decrease

to keep output at full employment.

Therefore,

II is downward sloping.

Interpretation

Right of II

• Overemployment
• Economy overheats

Left of II

• Underemployment
• Aggregate demand too low

External Balance (XX)

Definition

External balance exists when the current account reaches its target level.

\[CA\left(\frac{EP^*}{P},A\right)=X\]

where

• X is the desired current-account balance.

Economic Intuition

Depreciation improves the current account.

Higher domestic spending worsens the current account because imports increase.

Therefore, after a depreciation, higher spending is needed to offset the improvement in the current account.

As both variables move in the same direction,

XX is upward sloping.

Interpretation

Above XX

Current account surplus is too large.

Below XX

Current account deficit is too large.

The Four Zones of Economic Discomfort

The intersection of II and XX divides the economy into four regions.

Zone 1

• Overemployment
• Excessive current account surplus

Economy is overheating while exporting too much.

Zone 2

• Overemployment
• Excessive current account deficit

Demand is too strong but imports exceed sustainable levels.

Zone 3

• Underemployment
• Excessive current account deficit

This is often the most problematic situation because both objectives are missed.

Zone 4

• Underemployment
• Excessive current account surplus

Domestic demand is too weak despite a strong external position.

Policy Instruments

The model distinguishes two broad policy tools.

Expenditure-Changing Policies

Policies that change total domestic demand.

Main example:

• Fiscal policy.

Examples:

• increase government spending;
• reduce taxes;
• reduce government spending;
• increase taxes.

These policies move the economy horizontally by changing A.

Expenditure-Switching Policies

Policies that change demand between domestic and foreign goods.

Main example:

• exchange-rate changes.

Examples:

• devaluation;
• revaluation.

These policies move the economy vertically by changing E.

Policy Mix

In general,

both policy instruments are needed simultaneously.

Fiscal policy alone usually cannot achieve both objectives.

Similarly,

exchange-rate policy alone is generally insufficient.

The optimal policy combines:

• expenditure-changing policy;
• expenditure-switching policy.

The intersection of II and XX identifies this policy mix.

Bretton Woods Interpretation

Under Bretton Woods:

• exchange-rate changes were supposed to be infrequent;
• fiscal policy became the principal stabilization tool;
• monetary policy was largely unavailable because fixed exchange rates eliminated monetary independence.

This created policy dilemmas.

For example,

if the economy experienced:

• unemployment;
• current account deficit;

fiscal expansion reduced unemployment but worsened the deficit.

Fiscal contraction improved the external balance but increased unemployment.

Only a combination of:

• currency devaluation;
• fiscal expansion;

could restore both internal and external balance.

Economic Intuition

The model illustrates Tinbergen's Principle:

Two independent policy objectives require two independent policy instruments.

Internal balance and external balance cannot generally be achieved with only one instrument.

The framework explains why governments often need both:

• fiscal policy;
• exchange-rate policy.

Advantages

• Simple graphical representation.
• Simultaneously analyzes internal and external objectives.
• Useful under both fixed and floating exchange rates.
• Clearly illustrates policy trade-offs.
• Explains many historical policy decisions.

Limitations

• Short-run framework.
• Assumes fixed domestic and foreign prices.
• Simplifies fiscal and exchange-rate transmission mechanisms.
• Does not explicitly model expectations.
• Ignores many financial-market complexities.

Connections

• Internal Balance
• External Balance
• Bretton Woods System
• Floating Exchange Rates
• Monetary Trilemma
• Fiscal Policy
• Exchange Rate Policy
• Current Account
• Aggregate Demand
• Devaluation
• Revaluation
• Tinbergen Principle

Questions

• Why is the II schedule downward sloping?
• Why is the XX schedule upward sloping?
• Why does depreciation increase output?
• Why does higher domestic spending worsen the current account?
• What are expenditure-changing policies?
• What are expenditure-switching policies?
• Why is one policy instrument generally insufficient?
• Which zone is the most difficult for policymakers?
• How did Bretton Woods restrict the available policy mix?

Common Misconceptions

"Fiscal policy alone can usually achieve both goals."

False.

One instrument generally cannot achieve two independent objectives.

"The framework only applies to Bretton Woods."

False.

Krugman explicitly states that it applies under both fixed and floating exchange rates.

"Exchange-rate policy only affects the current account."

False.

Exchange-rate changes influence both aggregate demand and the current account.

Key Takeaways

• The framework analyzes how to achieve internal and external balance simultaneously.
• The II schedule represents combinations of E and A that maintain full employment.
• The XX schedule represents combinations of E and A that maintain the target current account.
• II slopes downward because depreciation and spending both increase output.
• XX slopes upward because depreciation improves the current account while spending worsens it.
• The intersection of II and XX represents the optimal policy mix.
• Fiscal policy changes domestic expenditure.
• Exchange-rate policy switches expenditure between domestic and foreign goods.
• The model illustrates why two policy objectives generally require two policy instruments.