Macroeconomic Balance in Cases of the Fixed and Floating Exchange Rates

The Nature and the Purpose of T. Swan Diagram

In the open economy in case of the development of macroeconomic policy it is necessary to solve two main problems. One of it aims to achieve an internal balance, and the second - to achieve an external balance.

The internal balance of the government is a state of economy which is at the level of potential production volume, i.e. it supports a full employment in the country and the internal price level is stable. The external balance is reached when it isn't observed an excessive deficit of current account and balance of current account equals or is close to zero.

According to Tinbergen's Rule, provision of the internal and external balance requires two independent instruments of economic policy. There are two types of economic policy for achieving a balance: expenditure changing policy and expenditure diversion policy. Expenditure changing policy is a policy of demand management which is directed on income and employment changes, and is performed in the form of fiscal or monetary policy. Expenditure diversion policy is a policy of demand management which is performed through management of the exchange rate and it influences structure of expenses on foreign and domestic goods. It influences not only on account balance of current transactions, but also on overall demand.

Expenditure changing policy provides change of government expenditures, taxes and change of money supply in the country, that later influence the interest rates. Expenditure diversion policy uses devaluation and revaluation of currency for the purpose of influence on balance of the current balance. Devaluation raises internal prices of import and reduces foreign price of export that leads to improvement of the account of current transactions. Using such instrument as devaluation/revaluation for improvement of balance of the current balance it is necessary to consider a condition of Marshall - Lerner [6 , p.194].

Sometimes, in order to achieve internal and external balance is not enough to implement one of these policies. For example, it is impossible to use the expenditure diversion policy in case of fixed exchange rate. As a result there is the expenditure changing policy for achievement of internal and external balance. Using Swan diagram it is possible to determine a combination of the expenditure changing policy (fiscal and monetary) and the expenditure diversion policy (changes of currency rate) which are necessary to reach internal and external balance at the same time.

There are several assumptions in Swan diagram: in the economy two goods are made and consumed by domestic and foreign trade; a good of domestic trade isn't a good of international trade; it is considered a small open economy which has no effect on the level of world prices (level of goods); goods are ideal substitutes in the total demand and they are usual substitutes in production [6 , p.195 ].

Let's investigate fig. 8.1, that represents the Swan diagram (presented) [1, p. 193]. With its help It is possible to analyze a process of achievement of internal and external balance (with its help) in case of implementation of the expenditure changing policy and the expenditure diversion policy.

The vertical axis RER measures a real exchange rate of foreign currency. The horizontal axis measures real internal expenses or absorption (C+I+G), where C -consumption, I - investments, G - government expenditures. The curve EB represents various combinations of exchange rates and real internal expenses for achievement of external balance. A positive slope of the curve EB is explained by the fact that higher RER level (devaluation) will improve a trade balance under the condition of Marshall - Lerner that is balanced with growth of internal expenses (C+I+G) to cause the sufficient growth of import for safety of external balance.

Swan diagram

Figure 8.1. Swan diagram

The curve IB represents various combinations of exchange rates and real internal expenses which lead to internal balance (that is a full employment and absence of inflation). The curve IB has a negative slope as lower RER level (revaluation) worsens a trade balance reducing internal expenses. Therefore preserving internal balance requires increasing of real internal expenses. Simultaneous internal and external balance is reached at the point E that is at point of intersection of the curves IB and EB. All the points that are above the curve EB, corresponding to a positive account balance of current transactions of the balance of payment, those that are below - correspond to negative balance. All the points that are above the curve IB mean internal inflation, and the points that are below -mean availability of unemployment.

To analyze the state of the economy of the country we use the chart that illustrates 4 possible situations. The I area reflects a situation of a negative account balance of current transactions and unemployment, II area - a negative balance of current account and inflation, III area - a positive balance of current account and inflation, IV area - a positive balance of the current account and unemployment. The final goal is simultaneous achievement of internal and external balance at the point E. This requires the changes in government expenditures and the influence on the level of exchange rate.

And now there is an example when the economy is not in a point of balance, but at the point C (I area) where there is observed a deficit of the current account and unemployment. In order to achieve a balance, it is necessary to use two instruments of economic policy. Otherwise, using only the devaluation, it is possible to reach only the external balance equilibrium in terms of unemployment, i.e. it is impossible to reach an external and internal balance at the same time. Thus, to achieve the balance at the point C, except devaluation, it is necessary to use an increase of the government expenditures.

So, Swan diagram shows how to reach an internal and external balance at the same time by combination of policies, if one of the instruments of macroeconomic regulation is the exchange rate (i.e. the exchange rate is not fixed). The actual use of expenditure diversion policy is impossible in case of the fixed exchange rate. As a result, the country has only expenditure changing policy for achievement of internal and external balance. The solution of this problem was proposed by R. Mundell, (showing) he proved how it is possible to reach the internal and external balance at the same time in case of the fixed exchange rate without implementing the expenditure diversion policy.

 
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