The unit explored the concept of internal and external equilibrium or balance as
relate to macroeconomic stability. The internal balance refers to internal stability such as low inflation, low unemployment and equitable income distribution while external balance or equilibrium refers to external stability such as balance of payment and equilibrium exchange rate. The unit also shed light on macroeconomic adjustment under fixed exchange rate on both external and internal equilibrium, it equally explain the adjustment process and changes in macroeconomic variables, for instance what happens when government
spending brings disequilibrium to AS and AD, i.e. an outwards shift to the IS,
prices rises and real money supply or demand falls, thereby lead to a backward
shift to LM which resulted to an increase in rate of interest.
At the end of this unit student should be able to; i)
Explain what is meant by internal balance.
ii) Explain what is meant by external balance.
iii) Understand linkages between internal and external balance.
iv) Understand instrument of internal equilibrium.
v) Understand instrument of external equilibrium.
vi) Explain how monetary and fiscal policy could be used to achieve both internal and external balance (equilibrium)
vii) Understand factors that could generate disequilibrium to both internal and external balance.
viii) Understand fiscal and monetary behaviour and direction of shift in IS and LM curve shift.
ix) Understand the resultant effect(s) of any policy adjustment.
Internal Balance or Equilibrium
Internal balance in economics is a state in which a country maintains full employment and price level stability. It is a function of a country's total output,
II = C (Yf - T) + I + G + CA (E x P*/P, Yf -T; Yf* - T*)
Internal balance = Consumption [determined by disposable income] +
Investment + Government Spending + Current Account (determined by the real
exchange rate, disposable income of home country and disposable income of the foreign country). Internal Balance can also be explain as macroeconomic
situation, where Aggregate Demand equals Aggregate Supply (potential output).
And there is full employment in the labour market. With sluggish wage and price
adjustment, lower AD causes a recession. Only when AD returns to potential
output is internal balance restored.
Internal Balance under Fixed Exchange Rate System
An internal equilibrium is achieved at the full employment and stable prices. If
there is an inflationary pressure or unemployment, the economy will require
further adjustment in prices or move toward the full employment output level..
(i) product market:
y(1 - b + m) = a + i(r¯) + g + x ; b = Marginal Propensity to Consume, m =
Marginal Propensity to Import.
(ii) money market:
m
s
= l(r) + ky; l(r) = liquidity balance, ky = transactions balance (k > 0, not
capital-labor ratio)..
An internal equilibrium is attained when the output is at the full employment
level. An increase in g shifts the IS curve to the right, thereby raising the interest
rate. Moreover, because the economy is fully employed, real output cannot
increased beyond y
F
. Thus, an increase in g increases inflationary pressure, thereby raising domestic price, which shifts the LM curve to the left. Thus, along the IE function, government spending and interest rate are directly related. That is, in order to maintain the full employment rate of output, any increase in government spending must be accompanied by a rise in the interest rate.
What happens to the money supply? It does not stay put. The aggregate output
demand (at the intersection of IS' and LM) exceeds the full employment output
y
F
. Accordingly, price level rises, which reduces the real money supply (M
S
/P),
thereby shifting the LM curve to the left to LM' and raising the domestic interest
rate.
Self Assessment Exercise
i. Explain what is meant by internal equilibrium to an economy
ii. What are the major factors responsible for internal equilibrium?
iii. Use both fiscal and monetary policy instrument to restore internal balance.
iv. Examine the existence of sudden upsurge to an equilibrating economy.
External Balance or Equilibrium
External balance signifies a condition in which the country's current account, its
exports minus imports, is neither too far in surplus nor in deficit. It is signified by a level of the current account which is consistent with the maintenance of
existing (or growing) levels of consumption, employment and national output over the long term. It is notated by
XX = CA (EP*/P, Y-T, Yf* - T*)
External balance = the right amount of surplus or deficit in the current account.
Maintaining both internal and external balances requires use of both monetary
policy and fiscal policy. That is one reason why floating exchange rates may be
superior to fixed exchange rates. Under fixed exchange rates, governments are
not usually free to employ monetary policy. Under floating rates, countries can use both.
External Balance – this refers to the Current Account balance. The country is
neither under spending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the
current account is in balance then also implies that the sum of the capital and
financial accounts are in balance.
External Balance under Fixed Exchange Rate System
BP = X(p¯,e
+
,y*
+
) ¯ M(p
+
,e¯,y
+
) + F(r+
)
An external equilibrium refers to a balance of payments equilibrium of an open
economy. Note that when an open economy achieves an external equilibrium, output y is not necessarily at the full employment rate.
As g increases, output y also increases (through the multiplier effect), which in
turn creates a current account deficit. To offset this, under the fixed exchange
rate system, the capital account has to improve, which can be realized by an
increase in the interest rate. (If the exchange rates are allowed to move freely, the market will find the equilibrium value of e).
Thus, an external equilibrium requires a positive relationship between government expenditure and interest rate.It is generally believed that EE function (curve) is steeper than the IE curve in the (g,r) space.
Self Assessment Exercise
i. Explain what is meant by external equilibrium to an economy
ii. What are the major factors responsible for external equilibrium?
iii. Use both fiscal and monetary policy instrument to restore external balance.
iv. Examine the existence of sudden external shock to an equilibrating economy.
Links between Internal and External Balance or Equilibrium
Internal balance or equilibrium is the most desirable of every economy and essence of having ministry of economic planning (as the case in Nigeria) notwithstanding, external balance is equally very desirable but internal first.
Some economies have little or no worries about external balance because their
international component of trade and fund transfer is negligible this imply modern autarky - a situation where an economy is closed has no economic relationship with rest of the world but because in reality the such an economy hardly exist then the definition change to the former. It is noteworthy that aggregate domestic absorption, i.e. Y = C + I + G -------------(1) equation is known as aggregate domestic absorption (A) and also mean a closed economy.
That is, Y = A --------(2) . However, if Y = C + I + G + (X - M) ----------- (3)
which imply a movement from autarky, then Y = A + (X - M) --------------( 4), if
A is taken to the LHS the equation (4) become, Y - A = X - M --------------(5) or
in a layman language, aggregate supply less aggregate demand equate export less import (net export), meaning that internal balance will lead external balance ceteris paribus. Alternatively, we can say that equilibrium exist both internally
and externally if equation (5) equals zero i.e. Y - A = X - M = 0 ------------( 6)
Self Assessment Exercise
i. Differentiate between external equilibrium to an economy
ii. What are the major factors could cause external disequilibrium?
iii. What does equation (6) stand for?
iv. Suppose LHS of equation (5) is greater than the RHS, what policy could restore equilibrium.
iv. Reverse the case in question (iv) above.
Conclusion
The unit survey the concept of internal and external equilibrium and sufficiently explain factor that can bring about disequilibrium and how equilibrium could
also be restored through the use of both fiscal and monetary policy. The unit
equally recognized that major imbalance could be brought about through fiscal
indiscipline or recklessness and monetary misapplication.
Summary
The unit review concepts of internal and external balance and reiterate that
imbalance or disequilibrium could be as a result of both internal and external
shocks and that stability could be restored through application of fiscal and monetary policies.
Marked Assignment.
i. Differentiate between external equilibrium to an economy
ii. What are the major factors could cause external disequilibrium?
iii. What does equation (6) stand for?.
iv. Suppose LHS of equation (5) is greater than the RHS, what policy could restore equilibrium.
v. What are the major factors responsible for internal equilibrium?
vi. Use both fiscal and monetary policy instrument to restore internal balance.
vii. Examine the existence of sudden upsurge to an equilibrating economy.
viii. What are the major factors responsible for internal equilibrium?
ix. Use both fiscal and monetary policy instrument to restore internal balance.
x. Examine the existence of sudden upsurge to an equilibrating economy.
References/Further Readings
Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles, Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Amacher, R and Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso
Bakare –Aremu T.A, (2013); Fundamental of Economics Principles (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Bakare I.A.O, Daisi, O.R., Jenrola, O.A., & Okunnu, M.A., (1999): Principles
and Practice of Economics (Macro Approach), Raamson Printing Press,
Mushin, Lagos, NigeriaDennis R. A. et-al; International Economics, Mcgraw
Hill Irwin, 8th edition.
Familoni K.A, (1990); Development in Macroeconomics Policy, Concept
Publications, Lagos, Nigeria
Fashina E.O, (2000); Foundations of Economics Analysis (Macro Theories),
F.E.F International Company, Ikeja, Lagos, Nigeria
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