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Internal External Balance Essay

When all you have is a hammer, everything looks like a nail. Bernard Baruch

In review of trade policy best suited for our Nation it is time for an overhaul and start developing a more complete toolbox. As Kevin Kaiser so poignantly stated in his article in CNN Money:

“The economists that make the world’s crucial monetary policy decisions are the same economists who authored most textbooks in use. While superficially appealing, their theories lack empirical evidence, are riddled with internal inconsistencies, and are based upon tenuous assumptions. Specifically, their models are built on downward sloping demand curves, upward sloping supply curves, perfect competition, rational consumers, benevolent dictators, and general equilibrium; there is no dynamic analysis, no consideration of disequilibrium, and no role of private sector debt” (Kaiser, 2011).

The policy cross as shown to the left indicates that as e increases m decreases, and current account improves. To offset this, an increase in g is required. The EE curve is positively sloped in the (e,g) space. An internal equilibrium is attained when the output is at the full employment level thereby raising the interest rate. Moreover, because the economy is fully employed, real output cannot increased beyond a point. Thus, an increase in inflationary pressure occurs, thereby raising domestic price, which shifts the LM curve to the left. Thus, along the IE curve, government spending and interest rate are directly related.

As a Post Keynes-Industrialist, the tendency to lean towards comprehensive human market behaviors and interdependent structural issues makes developing a one-size-fits-all policy, such as the policy cross, for internal and external balance a challenge. This is particularly true when evidence for any one theory to-date has not proven to be exact and reliable. Capitalism is fickle, and doesn’t follow slopes as neatly as theorists would like and the global shocks being felt around the world are keeping the economic status of all countries anything but predictable. Paul Krugman wrote an article for The New York Times that explained, “at the heart of the profession of economics’ failure has been its emphasis on rigor, rather than relevance—that is, economics had been weakened by the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess. He offered two recommendations in addition to again making the case for renewed attention to Keynes: scholarship that questions the efficient-market view of the financial sector, and research that incorporates the realities of finance into macroeconomics” (Krugman, 2009).

For the purposes of this paper however, it would be recommended that a floating exchange rate be proposed for the following reason: The challenge of fiscal and monetary policies to keep equilibrium could be comparative to eyeballing mass versus weight of internal and external spending and determining which is more relevant at any given time. While a cleanly floating exchange rate assures external balance, it does not assure internal balance and changes in the rate to achieve external balance may exacerbate and internal imbalance. Government monetary and fiscal policies may be used to address internal imbalances at this point with a floating rate structure.

“The following graph can assist in understanding the impacts of booms and recessions on internal and external balances.”(Johnston, M. 2011). For example, the bottom left-hand shows the effects of exports being less competitive, which reduces the number of exports and induces a current account deficit and lower aggregate demand. Currently, the US has a well-known financial problem with a large trade deficit every year. “It seems many ignore this issue since our debts tend to be denominated in our domestic currency, the dollar.” (Kling, A. para 6). The most recent news release for second quarter 2012 on the Bureau of Economic Analysis states, “the US current-account deficit decreased to $117.4 billion (preliminary) in the second quarter from $133.6 billion (revised) in the first quarter. The decrease in the current-account deficit was accounted for by a decrease in the deficit on goods and an increase in the surplus on income.”(Bea.gov, Sept 18, 2012). This would indicate a small shift in the left lower quadrant just slightly contracting, but very little overall.

However damning the current financial situation is, the floating exchange rate remains the better choice as argued in Global Business Today, “Under a fixed system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity, leading to high interest rates” (Hill, 2011). “Another reason is the because the real exchange rate fundamentals including terms of trade, import tariffs, technology progress, composition of government expenditures and revenues, real interest rate and capital controls are always in flux” (Wong, C. p. 7). When the exchange rate is flexible, in fiscal expansion either government expenditure increases or tax cuts raises output, but worsens current account balances. Conversely, fiscal contraction improves current account balances, but lowers output. If the economy attempts to attain both internal and external balance it could consider expenditure switching, but alone this will be inadequate.

“For example, if an economy is at the full employment level, i.e., internal balance is already attained, but if it is running current account deficits, policy makers in the economy could devalue its currency so that net exports rise. However, the improvement of current account balances would lead the economy to experience over-heating so that internal balance would disappear. If an economy is experiencing an inflationary gap, or over-heating, while maintaining balanced current account, a revaluation policy may reduce total expenditure back to the full employment level, but lead to current account deficits” (web.pdx.edu, para 5). Therefore, changing how we currently think may be necessary to achieve both internal and external balances.

Economics has been referred to the dismal science but as Kaiser states, “True sciences expand and evolve: genetics, psychology, quantum mechanics, astronomy. Economics defends itself – it is an ideology. What we need is an economic theory that is more relevant to a modern capitalist economy – one that embraces uncertainty and disequilibrium, is grounded upon realistic assumptions, is judged by the accuracy of its predictions, and where debt and money are implicit, important factors.” (CNN Money, 2011).

References

Hill, H. (2011). Global Business Today. New York: New York McGraw-Hill

Kaiser, K. (December 16, 2011) It’s time for economic theory to evolve. CNN Money. Retrieved on December 14, 2012 from http://finance.fortune.cnn.com/2011/12/16/its-time-for-economic-theory-to-evolve/

Johnston, M (October 8, 2011). AS and A2 Macroeconomics: Internal and External Balances. Econofix. Retrieved on December 12, 2012 from http://econfix.wordpress.com/2011/10/08/as-and-a2-macroeconomics-internal-and-external-balances/

Kling, A. (2004). The trade balance. Retrieved on December 13, 2012 from http://arnoldkling.com/econ/macro/trade.html

Krugman, P (2009). “How Did Economists Get It So Wrong?” The New York Times, September 2. Retrieved on December 14, 2012 from http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html

News Release: US International Transactions. Retrieved on December 14, 2012 from http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm

Wong, C-H. Adjustment and the Internal-External Balance. Retrieved on December 14, 2012 from http://rbidocs.rbi.org.in/rdocs/content/pdfs/L-1b.pdf

World Economy Expenditure Changing Retrieved on December 14, 2012 from http://web.pdx.edu/~ito/Expenditure_changing_switching_RE_-HI.pdf


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