Expenditure changing and expenditure switching: Internal and External Balances
The interaction between internal and external balances can be demonstrated through a simple Keynesian model where consumption is a function of disposable income; the current account is related to the real exchange rate and disposable income (while foreign income that affects the domestic country’s exports is assumed to be constant); and investment and government spending are exogenous. Internal and external balances are:
Internal balance (II):
Y ¼Y f ¼C(Y f T)þI þG þCA(EP*=P, Y f T) External balance (XX): CA¼CA(EP*=P, Y T)¼XX
where XX is a sustainable amount of current account deficit or surplus.
When the exchange rate is flexible, fiscal expansion either government expenditure increase or tax cuts raises output but worsens current account balances. Conversely, a fiscal contraction improves current account balances but lowers output. More specifically, if a countrywants to raise its income level through fiscal expansion, it would have to experience a worsening in trade balances, because expansionary fiscal policy would lead to a rise in imports through improved disposable income and, therefore, worsens current account balances. Alternatively, if a country with a current account deficit attempts to reduce it, it could achieve that by implementing contractionary fiscal or monetary policy, so that as to reduce imports. When a countrywants to achieve both internal and external balances simultaneously, it ismost effective if the country lets the value of its currency change, so that change in the real exchange rate can affect both the economy’s total demand and the demand for imports. Such policy to achieve current account balances by manipulating the demand for domestic and foreign goods through changes in the value of the currency is called expenditure switching policy.
When expenditure switching policy is not available that is, when an economy is under the fixed exchange rate regime expenditure changing policy through fiscal policy becomes the only available policy tool for attaining internal and external balances. In the fixed exchange rate system, monetary policy becomes unavailable because it affects the interest rate and the exchange rate. However, fiscal policy is insufficient to achieve both internal and external balances in such an environment.