Two Systems of Policy Response

Monetary and Fiscal policy can be utilized in two different ways when internal and external
balance has not been simultaneously achieved.
1) Monetary policy can be used to achieve internal equilibrium i.e. AD=Y* while fiscal
policy is utilized towards ensuring external stability i.e. Balance of trade= Net export of
capital
2) Fiscal policy may be used for internal stability while monetary policy is used to ensure
external stability.

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The first policy system in which the interest rate is used to maintain internal stability while the
budget surplus is used for the purpose of external stability is an unstable policy system. For
example, suppose that there exists full employment combined with a balance of payments
deficit (at W). If fiscal policy is to be used to address the B.O.P deficit, the budget surplus must
increase in order to decrease imports. The budget surplus thus increases by WV. At V there will
be B.O.P equilibrium but the increase in budget surplus will have cause unemployment.
Since monetary policy is being used to ensure internal equilibrium, the interest rate must
decrease (by VU) to stimulate aggregate demand and return the economy to full employment.
However, the decrease in interest rate precipitates an outflow of capital resulting in (once
more) a B.O.P deficit at the point U necessitating another increase in the budget surplus. The
process continues with the interest rate and budget surplus moving further away from the
equilibrium with each policy intervention.
The B.O.P deficit at U is higher than the B.O.P deficit at W. This is because, though the balance
of trade is constant at both points, the balance of payments or net capital exports are far lower
at U than they were at W. It is clear then that this sort of policy intervention where fiscal policy
targets external stability and monetary policy targets internal equilibrium is unstable.
The opposite type of policy response is stable. Suppose that the economy is at the same
disequilibrium point W. Fiscal policy is geared towards internal equilibrium while monetary
policy is used to maintain external equilibrium. Since there is a B.O.P deficit at W, interest rate
must increase to stimulate net capital exports (from W to B). The interest hike corrects the
external balance but leads to unemployment which has to be addressed by decreasing the
budget surplus (from B to C). At C there is, once more, internal balance combined with a
payments deficit. However the deficit at C is less than the deficit at W: while the balance of
trade at both C and W is the same, net capital exports are higher at C. The lower deficit at C
indicates that the policy system is stable.
Observing the diagram, it is clear that at W the budget surplus is higher and the interest rate is
lower than the equilibrium levels indicating that budget surplus must decrease and interest rate
must rise. The use of fiscal policy for external balance and monetary policy for internal balance
drive the budget surplus and interest rate away from the equilibrium levels while the alternate
system moves them closer to equilibrium. Hence fiscal policy should be geared towards internal
balance and monetary policy towards external balance and not vice versa. The same argument
applies to a point of disequilibrium representing B.O.P surplus and inflationary pressures. Here,
interest rate must be reduced and fiscal policy must be made more restrictive i.e. higher budget
surplus. For any other disequilibrium, such as B.O.P deficit accompanied by inflationary
pressures or B.O.P surplus combined with deflationary pressures, monetary and fiscal policy will
move in the same direction (both restrictive in the former case and both expansionary in the
latter).
Conclusion
It is thus clear that in countries where employment and balance of payment policies are
restricted to fiscal policy and monetary policy (exchange rate cannot be altered and tariffs
cannot be imposed) monetary policy should be used for attaining balance of payments
equilibrium while fiscal policy should aim at ensuring full employment. The opposite policy
system would lead to a progressive deterioration in the B.O.P and employment level.
Further support for this argument is given by the Principle of Effective Market Classification
according to which policies should be directed towards those policy objectives on which they
have the most influence. The use of fiscal policy for external balance and monetary policy for
internal balance violates this principle because the ratio of the effect of the rate of interest on
internal stability to the effect of rate of interest on the balance of payments is less than the
ratio of the effect of fiscal policy on internal balance to its effect on external balance. Therefore
the opposite set of policy responses is consistent with the Principle of Effective Market
Classification.