The Essence of Internal and External Equilibrium
The problems of macroeconomic equilibrium is in the centre of economic theory since the Great Depression of 1929-1933. John Maynard Keynes determined the achieving of "full employment)) by the means of aggregate demand regulation as a priority of the economic policy. Monetarists determined the economic growth without inflation as a main goal of the economic policy and proposed the monetary rule as a means of achieving it . Proponents of the theory of rational expectations believed that the lack of confidence in the government is the main obstacle for achieving the potential level of output together with the lowest level of inflation.
Maintaining internal and external balance still remains a major challenge for macroeconomic regulation. The solution of this task requires proper attention to the correlation between the main macroeconomic variables that characterize the internal state of the economy and are mediated by external processes. At the same time, the economic variables that reflect the external sector state is under the influence on influence on internal variables. All this makes it more difficult to carry out macroeconomic policy, which requires the increasing number of factors to be taken into account.
In various models of an open economy there are different interpretations of the internal and external balance, but the meaning remains the same. In a broad sense, the internal equilibrium is the equilibrium of the national income, and the external equilibrium is the equilibrium of balance of payments.
The internal equilibrium require the balance of supply and demand together with full employment and absence of inflation (or its stable low level). In the short term, this problem can be solved by regulation of aggregate demand through fiscal and monetary policy. According to the approach of the classical school, the internal equilibrium means a stable state of income (Yn) on a certain "natural" level that indicates indicates the availability of capital and labor resources. In the Keynesian theory the "natural" level of income is understood as the non-inflationary rate of unemployment.
The external equilibrium means a maintenance of a zero balance of payments in terms of a certain exchange rate regime. The maintaining of external equilibrium may reflect two main objectives: to achieve a certain state of the current account and to maintain a certain level of foreign exchange reserves. Macroeconomic regulation is provided by monetary and fiscal policy. The goal of the external equilibrium is complicated by capital mobility - intensity of the cross-country mobility of capital in response to interest rate fluctuations.
In fact, the maintenance of internal and external equilibrium refers to the functioning of three markets: goods, money and foreign exchange markets.
Tools of Economic Policy Used for Balance in Economy
The functioning of the market does not always lead to a satisfactory equilibrium (balance). Government intervention becomes necessary to regulate the economy. The government is developing the economic policies to achieve macroeconomic equilibrium.
An economic policy is a set of various measures taken by the government in order to achieve the specific goals of economic development, which is a complex social mechanism. It aims to reach the following objectives:
• economic growth, determined by the rate of GDP growth;
• full employment, defined by the level of unemployment;
• price stability, defined by the rate of inflation;
• external account balance that is reflected in the accounts of balance of payments.
There are two main types of economic policy depending on the purpose pursued by the government:
• cyclical policy, which is used to compensate the temporary reduction in economic activity;
• structural policy, which is used to change the economic and social structure. Long-term goals are laid down in the basis of the structural policy. It contains measures affecting employment, tax policy, industry and agriculture, health care system, environmental policy, the system of social protection of the population, etc., which give results only in the long term.
The economic policy is more effective when the decisions are taken by the government with a focus on specific current conditions - production and technical potential, the state of the social structure, the institutional order of national and local government, etc.
For the implementation of economic policy by the state, the following macro-economic instruments are used:
• fiscal policy;
• monetary policy.
Fiscal policy represents as measures affecting public spending, taxation and the government's budget in order to ensure full employment, an equilibrium of balance of payments and economic growth.
Instruments of fiscal policy are the costs and revenues of the state budget: public procurement, taxes, transfers. In this regard, there are two types of fiscal policy - facilitating and moderating policy.
Facilitating fiscal policy (expansionary fiscal policy) aimes at overcoming the cyclical downturn of the economy in the short term, implies an increase in government spending, tax cuts or a combination of these measures. In the long term, such policy leads to the growth of the economic potential of the country.
Restrictive fiscal policy in the short term is to reduce inflationary demand and slowing the decline in production. For this purpose, measures such as: reducing government spending, tax increases, and the combination of these measures are used.
Monetary policy represents as measures of authorities to influence on money supply, interest rates, and through them - on investment and real GDP using direct and indirect instruments of regulation.
The direct instruments include administrative measures such as directives of the central bank. Credit limits and direct regulation of interest rates provide the most rapid economic effect. But usually, in a market economy the implementation of monetary policy is provided by indirect instruments.
The indirect instruments include such measures as changes of reserve requirements, interest rates and open market operations.
Reserve requirements are determined as a percentage of total deposits. The central bank manipulating the statutory reserve ratio affects the ability of commercial banks to lend .
Raising reserve rate increases the amount of required reserves that banks must hold. This tool affects the decline in bank lending due to the loss of excess reserves, or forcing banks to reduce deposits and thus the money supply. Decrease in reserve rate moves required reserves in excess and increases the ability of banks to create new money by lending.
One of the traditional functions of a central bank is providing loans to commercial banks, and the interest rate, which the loan is issued at, is called the discount rate. Changing the discount rate affects the volume of reserves of commercial banks, reducing or increasing their ability to lend. Thus, the increase in the discount rate leads to a decrease in reserves, thereby reducing the ability of the bank to create money by lending.
For countries with developed stock market transactions in the open market are the most important means of controlling the money supply by the central bank. Application of this method is difficult in the emerging stock market. This tool involves the buying and selling of government securities by the central bank. A purchase of securities is accomplished by transfering the securities portfolios of commercial banks to central banks which in their turns pay for these securities by increasing the reserves of commercial banks in the amount of the purchase. A sale of securities is fulfilled by transfering securities from the central bank to commercial banks, that reduces their reserves.
Monetary policy, as well as fiscal, has two types: expansionary and constractionary.
Expansionary monetary policy is called as a policy of "cheap" money. Among its tasks are making credits cheaper, facilitating access to it, in order to increase aggregate demand and employment. For this purpose the reduction of reserve ratio, lowering the discount rate and the purchase of securities are used.
Restrictionary monetary policy (a policy of "expensive money") aims to reduce the money supply in order to reduce costs and curb inflation. To maintain such a policy it is necessary to raise the reserve requirement and the discount rate, and also sale government securities.
Most economists believe that monetary policy is an important part of the economic stabilization policies, some of the scientific schools pay more attention to fiscal policy.
In the Keynesian model fiscal policy is seen as the most effective instrument of macroeconomic stabilization, as government spendings has a direct impact on the value of aggregate demand and multiplicative effect on consumer spendings. At the same time taxes are quite effective) influence on consumption and investment. In the classical model fiscal policy plays a secondary role in comparison with the monetary one. Moreover, fiscal measures cause crowding-out effect and enhance the increase in the rate of inflation, that significantly reduces its incentive effect.
In the Keynesian model monetary policy is seen as a secondary towards fiscal, because the monetary policy transmission mechanism is very complex: the change in money supply leads to changes in GDP through the mechanism of change in investment spendings, which respond to the dynamics of the interest rate. In the classical model it is assumed that the change in the money supply directly affects aggregate demand and, consequently, the nominal GDP.
In the modern market economy it is taken as a rule, first of all, to consider monetary measures, and then - fiscal. This is due to the fact that the implementation of monetary policy to a greater extent reflects the typical balance of the market and the state origins in the economy.
In various models there are different approaches to macroeconomic equilibrium due to the objectives and instruments. Dutch economist J. Tinbergen worked out the rule that to achieve N goals it is necessary to use N different instruments. Thus, if there is a double set of objectives of macroeconomic equilibrium, such as income and balance of payments, it is necessary to use two independent instrument of economic policy.