Ensuring Internal and External Balances Simultaneously

P.S. As I thought that the subchapter “Combining Exchange Rate and Fiscal Policies” in the
Chapter 18 by Blanchard (2021: pp.387-388) is not enough to understand this topic enough, I have
prepared the extra material consisting of 5 cases, which of whom last 4 cases match with the
following policy prescription in page 388:
 Internal balance is the case when the output level is equal to YF, the potential output which is
the maximum level of final goods and services that can be reached when an economy is the most
efficient or when it is at the full capacity. External balance is the case when 𝑁𝑋 = 0 or when the trade
balance occurs in an economy. Policy makers need to follow fiscal and/or the exchange rate policies
in order to reach these balances simultaneously.

Case 1: 𝒀 = 𝒀𝑭 𝒂𝒏𝒅 𝑵𝑿 < 𝟎

Graph 1. Internal and Balances: 𝑌 = 𝑌𝐹 𝑎𝑛𝑑 𝑁𝑋 < 0

If in a situation where an internal balance (Y=YF) is achieved, a trade deficit (NX<0) has arisen, the
economic policy needs to be implemented such that it can eliminate the trade balance without
changing the output level. The remedy of following devaluation of the LCU against the FCU1 with
the contractionary fiscal policy can solve this problem. In the Graph 1, the economy is initially in the
equilibrium (at the full capacity) at E1 where the trade balance of the magnitude |𝑌𝐹 𝐺| is the case. In
order to achieve the external equilibrium, NX should be increased by 𝑑𝑁𝑋 = |𝑌𝐹 𝐺| so that it moves
from NX1 to NX2 via devaluation. When NX increases by dNX amount, ZZ increases by the same
amount, and thus the output increases from YF to Y1, where the internal balance deteriorates at E2.
However, in order to make the expansionary effect of the devaluation on the total demand up the

1
LCU: Local currency unit; FCU: Foreign currency unit
exchange rate policy should be supported by the contractionary fiscal policy by the magnitude of 𝑑𝐺 =
𝑑𝑁𝑋, as a result of which the balance moves from E2 to E1, simultaneously.

Case 2: 𝒀 < 𝒀𝑭 𝒂𝒏𝒅 𝑵𝑿 < 𝟎

Graph 2. Internal and Balances: 𝑌 < 𝑌𝐹 𝑎𝑛𝑑 𝑁𝑋 < 0

If in a situation where a deflationary gap (Y<YF) and a trade deficit (NX<0) have arisen, the economic
policy needs to be implemented such that it can eliminate both imbalances. The remedy of following
devaluation of the LCU with the contractionary fiscal policy can solve this problem. In the Graph 2,
the economy is initially in the equilibrium at E1 where the deflationary gap of |𝐸3 𝑆| and the trade
deficit of |𝑌1 𝐹| are the case. In order to achieve the two balances, NX should be increased by 𝑑𝑁𝑋 =
|𝐹𝐻| so that it moves from NX1 to NX2 via the devaluation. When NX increases by dNX amount,
ZZ increases by the same amount and it shifts from the ZZ1 (=AE1) to ZZ2 (=AE2)2, and thus the
output increases from Y1 to Y2, where the internal balance deteriorates at E2 as Y2>YF. However, in
order to make the over-effect of the expansionary effect of the devaluation on the total demand up
the exchange rate policy should be supported by the contractionary fiscal policy by the magnitude of
𝑑𝐺 < 𝑑𝑁𝑋, as a result of which the balance moves from E2 to E3, simultaneously.

2
AE stands for aggregate expenditure that equals exactly the total demand ZZ.
Case 3: 𝒀 < 𝒀𝑭 𝒂𝒏𝒅 𝑵𝑿 > 𝟎
Graph 3. Internal and Balances: 𝑌 < 𝑌𝐹 𝑎𝑛𝑑 𝑁𝑋 > 0

If in a situation where a deflationary gap (Y<YF) and a trade surplus (NX>0) have arisen, the economic
policy needs to be implemented such that it can eliminate both imbalances. The remedy of following
the expansionary fiscal policy with the devaluation of the LCU can solve this problem. In the Graph
3, the economy is initially in the equilibrium at E1 where the deflationary gap of |𝐸2 𝑆| and the trade
surplus of |𝑌1 𝐹| are the case. In order to achieve the two balances, the government spending should
be increased by 𝑑𝐺 = |𝐸2 𝑆| so that this may lead the ZZ to move upward by the same amount 𝑑𝐺 =
𝐺2 − 𝐺1 = |𝐸2 𝑆| from ZZ1 till ZZ2 at E2, where the internal balance occurs but the trade surplus turns
into the trade deficit of |𝑌𝐹 𝐻|. If the devaluation is followed in order to achieve the trade balance, the
NX shifts upward from the NX1 to NX2. On the other hand, when the NX increases by 𝑑𝑁𝑋 =
𝑁𝑋2 − 𝑁𝑋1 = |𝑌𝐹 𝐻|, the total demand ZZ increases by the same amount, which in turn increases the
output. Then in order to make the effect of the expansionary effect of the devaluation on the total
demand up the exchange rate policy should be supported by the contractionary fiscal policy of 𝑑𝐺 =
𝐺2 − 𝐺3 = 𝑑𝑁𝑋 = |𝑌𝐹 𝐻|.
Case 4: 𝒀 > 𝒀𝑭 𝒂𝒏𝒅 𝑵𝑿 < 𝟎
Graph 4. Internal and Balances: 𝑌 > 𝑌𝐹 𝑎𝑛𝑑 𝑁𝑋 < 0

If in a situation where an inflationary gap (Y>YF) and a trade deficit (NX<0) have arisen, the economic
policy needs to be implemented such that it can eliminate both imbalances. The remedy of following
the contractionary fiscal policy with the devaluation of the LCU can solve this problem. In the Graph
4, the economy is initially in the equilibrium at E1 where the inflationary gap of |𝐸2 𝑆| and the trade
deficit of |𝑌1 𝐹| are the case. In order to achieve the two balances, the government spending should
be decreased by 𝑑𝐺 = |𝐸2 𝑆| so that this may lead the ZZ to move downward by the same amount
𝑑𝐺 = 𝐺1 − 𝐺2 = |𝐸2 𝑆| from ZZ1 till ZZ2 at E2, where the internal balance occurs but still the trade
deficit of |𝑌𝐹 𝐻| is the case. If the devaluation is followed in order to achieve the trade balance, the
NX shifts upward from the NX1 to NX2. On the other hand, when the NX increases by 𝑑𝑁𝑋 =
𝑁𝑋2 − 𝑁𝑋1 = |𝑌𝐹 𝐻|, the total demand ZZ increases by the same amount, which in turn increases the
output from YF to Y2, where the internal balance deteriorates. Then in order to make the effect of the
devaluation on the total demand up the contractionary fiscal policy of 𝑑𝐺 = 𝐺2 − 𝐺3 = 𝑑𝑁𝑋 =
|𝑌𝐹 𝐻| should be used.

Case 5: 𝒀 > 𝒀𝑭 𝒂𝒏𝒅 𝑵𝑿 > 𝟎

Graph 5. Internal and Balances: 𝑌 > 𝑌𝐹 𝑎𝑛𝑑 𝑁𝑋 > 0

If in a situation where an inflationary gap (Y>YF) and a trade surplus (NX<0) have arisen, the
economic policy needs to be implemented such that it can eliminate both imbalances. The remedy of
following the revaluation of the LCU with the expansionary fiscal policy with can solve this problem.
In the Graph 5, the economy is initially in the equilibrium at E1 where the inflationary gap of |𝐸2 𝑆|
and the trade surplus of |𝑌1 𝐹| are the case. In order to achieve the two balances, firstly the revaluation
of the LCU should be followed that shifts the NX downward from NX1 to NX2 by 𝑑𝑁𝑋 = |𝑌𝐹 𝐻|,
which in turn decreases the ZZ from ZZ1 to ZZ2 by the same amount and thus the output decreases
from YF to Y2 till the new equilibrium E2, where there is no internal balance as Y2<YF. Then in order
to make the effect of the revaluation on the total demand up the expansionary fiscal policy of 𝑑𝐺 =
𝐺2 − 𝐺1 = |𝐸2 𝐵| should be followed.