internal-external balance model

Internal-external balance modelclick for a larger image
Fig. 96 Internal-external balance model. (a)

(b) Given the ratio of international to domestic prices (P), domestic demand must be at level X to secure internal balance. If it is not, the result is unemployment or inflation.

(c) Given the level of domestic demand (X), the ratio of international to domestic prices must be at level P to secure external balance. If it is not, the result is a surplus or deficit balance of payments.

internal-external balance model

a theoretical construct that seeks to integrate the achievement of the MACROECONOMIC POLICY objectives of FULL EMPLOYMENT and PRICE STABILITY (internal balance) and BALANCE OF PAYMENTS EQUILIBRIUM (external balance). A brief illustration of the model is given in Fig. 96 (a). The vertical axis shows the ratio of international prices to domestic prices. This is an index of the country's foreign competitive position: the higher one moves up the scale, the larger are exports and the smaller are imports. On the horizontal axis is domestic real demand, which increases from left to right. The two curves shown in the figure represent, respectively, external balance (EE) and internal balance (DD). The EE curve has a positive slope, indicating that the more unfavourable the international price ratio becomes, the lower domestic real demand must be to maintain balance-of-payments equilibrium. Positions to the left and above the curve represent payments surplus, to the right and below, deficit. The DD curve has a negative slope, indicating that the more unfavourable the international price ratio becomes, the higher domestic real demand must be to maintain full employment. Positions to the right and above the curve represent price inflation, to the left and below, unemployment.

Where the EE and DD curves intersect (point A), the country is in general equilibrium. All other positions represent disequilibrium. However, from only a few of these disequilibrium positions can the country attain the two policy objectives of internal and external equilibrium using just a single policy variable - specifically, from only those positions located on the horizontal and vertical dotted lines drawn through the intersection. In the situations shown by the horizontal line to the right of point A, for instance, the ratio of international to domestic prices is appropriate, but domestic real demand is too high, resulting in both inflation and a balance-of-payments deficit. DEFLATION of demand alone would therefore suffice to realize both goals. In situations shown by the vertical line below point A, domestic real demand is just right, but domestic prices are uncompetitive, resulting in both a balance-of-payments deficit and unemployment. A currency DEVALUATION alone would therefore suffice to realize both goals. However, these are special cases. In all other situations, both domestic demand and the international price ratio are inappropriate. As a result, the two policy objectives are in conflict, and the separate policy variables must be combined to be effective. In zones 1 and 2, for instance, varying combinations of demand-deflation and currency REVALUATION are required, and in zones 3 and 4, varying combinations of demand-deflation and currency devaluation. In zones 5 and 6, varying combinations of demand REFLATION and currency devaluation are required; and in zones 7 and 8, varying combinations of demand reflation and currency revaluation.