FISCAL AND MONETARY POLICY FOR INTERNAL AND EXTERNAL BALANCE

Abstract

In a by now classic article, R.A. Mundell demonstrated that an open economy could maintain internal and external balance without using the exchange rate as a policy tool. This, he showed, could be done by using fiscal policy to produce internal balance, and interest rate policy to produce an imbalance on the capital account to offset whatever imbalance there might be on the current account. There have been two criticisms of this analysis. The first, fairly common in the literature, is that it presumes international capital movements are flows. If, as is often maintained, they are stock adjustments, a certain amount of funds will move in response to an interest rate rise, and then to produce a further reallocation of portfolios a further rise in interest rates will be required. It is thus concluded that Mundellian policy in the presence of a current account deficit would have to be not merely interest rates above those elsewhere, but interest rates rising higher and higher above those elsewhere. The second criticism was first suggested by H.G. Johnson, and later developed in detail by John Williamson. They attacked not the feasibility of the policy, but its desirability. They argued that the policy would produce resource misallocation, both because it compels the choice between home and overseas investment to be made exclusively on short‐term balance of payments grounds, and because it distorts the consumption/investment mix at home.

Citation

WOOD, G.E. (1975), "FISCAL AND MONETARY POLICY FOR INTERNAL AND EXTERNAL BALANCE", Journal of Economic Studies, Vol. 2 No. 2, pp. 89-99. https://doi.org/10.1108/eb008051