Adjustment Policies

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 National objectives

Achieving internal balance

Full employment

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 National objectives

Achieving internal balance

Attaining external balance
Equilibrium in the balance of payments

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 National objectives

Achieving internal balance

Attaining external balance
A sustainable rate of economic growth

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 National objectives

Achieving internal balance

Attaining external balance
A sustainable rate of economic growth
An equitable distribution of income
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 National objectives

Achieving internal balance

Attaining external balance
A sustainable rate of economic growth
An equitable distribution of income
Adequate environmental protections
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 Policies for attaining internal and
external balance

Expenditure changing policies

Fiscal and monetary policy tools to alter the level
of aggregate expenditures in the economy.

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 Policies for attaining internal and
external balance

Expenditure changing policies

Expenditure switching policies
Devaluation or revaluation of the exchange rate to
alter the balance of spending on domestic and
foreign goods and services.

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 Policies for attaining internal and
external balance

Expenditure changing policies

Expenditure switching policies
Direct controls
intervention, exchange restriction, exchange
clearing agreements and payments agreements
Tariffs and non-tariff barriers used to alter the
international flow of goods and services.
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 Direct controls

Types of direct controls

 Trade controls (indirect)
 Tariffs and non-tariff barriers
 Exchange controls
 Restrictions on international financial flows
 Use of multiple exchange rates
The effectiveness of direct controls is limited as the effects
can be countered by international non-cooperation.

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 Types of imbalances

Internal imbalances
 Inflation imbalance
 Assumed to be caused by excess aggregate demand.
 Recession imbalance
 Caused by insufficient aggregate demand
 External imbalances
 A deficit in the balance of payments
 A surplus in the balance of payments
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 Types of imbalances
Possible situations
Inflation and balance of payments surplus
Recession and balance of payments surplus
Inflation and balance of payments deficit
Recession and balance of payments deficit
It is possible that the policies available for
correcting the imbalances may improve one
situation only at the expense of worsening another.

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Monetary policy with fixed exchange
rates

Expansionary monetary policy tends to lower interest

rates.
This policy would be appropriate to cure situations of
recession.

Expected effects
Greater investment and domestic income
Reduced financial inflows and/or increased financial
outflows
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Monetary policy with fixed exchange
rates

Expansionary monetary policy tends to lower

interest rates.
Situation 1: recession and balance of payments
surplus
The expansion in domestic investment and income
reduces the internal imbalance.
The fall in net financial inflows reduces the balance of
payments surplus.
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Monetary policy with fixed exchange
rates
Expansionary monetary policy tends to lower
interest rates.
Situation 2: recession and balance of
payments deficit
The expansion in domestic investment and income
reduces the internal imbalance.
The fall in net financial inflows increases the balance
of payments deficit.
The larger balance of payments deficit necessitates further government
or central bank action. 15
 Monetary policy with fixed exchange
rates
Situation 2: recession and balance of payments
deficit
Possible actions to close the balance of
payments deficit
Sell foreign currency and buy domestic currency
This counteracts the initial expansion of the money supply and reintroduces
the internal imbalance.

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 Monetary policy with fixed exchange
rates
Situation 2: recession and balance of payments
deficit
Possible actions to close the balance of
payments deficit
Sell foreign currency and buy domestic currency
Engage in sterilized currency intervention
Rather than sell foreign currency and buy domestic currency, the monetary
authority could buy government bonds.
The ability to engage in sterilized intervention is limited so this is at best a
short term solution.
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 Monetary policy with fixed exchange
rates
Situation 2: recession and balance of payments
deficit
Possible actions to close the balance of
payments deficit
Sell foreign currency and buy domestic currency
Engage in sterilized currency intervention
Alter the level at which the exchange rate is fixed
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 Fiscal policy with fixed exchange
rates

Expansionary fiscal policy tends to increase income

levels but also increase interest rates.
Higher interest rates arise from increased government
borrowing necessitated by deficit spending.

Expected effects
Lower investment but greater domestic income
Increased financial inflows and/or decreased financial
outflows
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 Fiscal policy with fixed exchange
rates

Expansionary fiscal policy tends to increase

income levels but also increase interest rates.
Situation 1: recession and balance of payments
deficit
The expansion in domestic income reduces the internal
imbalance.
The increase in net financial inflows reduces the
balance of payments deficit.
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 Fiscal policy with fixed exchange
rates
Expansionary fiscal policy tends to increase
income levels but also increase interest rates.
Situation 2: recession and balance of
payments surplus
The expansion in domestic income reduces the
internal imbalance.
The increase in net financial inflows increases the
balance of payments surplus.
The larger balance of payments surplus necessitates further government
or central bank action. 21
 Fiscal policy with fixed exchange
rates

Situation 2: recession and balance of payments

surplus
Possible actions to close the balance of
payments surplus
Buy foreign currency and sell domestic currency
The expansion in the domestic money supply serves to lower interest
rates and reinforce the expansionary effects of the fiscal policy.

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 Fiscal policy with fixed exchange
rates

Situation 2: recession and balance of payments

surplus
Possible actions to close the balance of
payments surplus
Buy foreign currency and sell domestic currency
Engage in sterilized currency intervention
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 Fiscal policy with fixed exchange
rates

Situation 2: recession and balance of payments

surplus
Possible actions to close the balance of
payments surplus
Buy foreign currency and sell domestic currency
Engage in sterilized currency intervention
Alter the level at which the exchange rate is fixed
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 Best policy choices
Inflation and balance of payments surplus:
Contractionary fiscal policy coupled with expansionary
monetary policy
Recession and balance of payments surplus:
Expansionary fiscal policy
Inflation and balance of payments deficit:
Contractionary fiscal policy
Recession and balance of payments deficit:
Expansionary fiscal policy and contractionary monetary policy
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 Monetary policy with flexible
exchange rates

With flexible exchange rates, external

balance is automatic.
Therefore, monetary and fiscal policy only act on
internal imbalances.

Expansionary monetary policy tends to lower

interest rates.
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 Monetary policy with flexible
exchange rates

With flexible exchange rates, external balance is

automatic.
Expansionary monetary policy tends to lower
interest rates.
Expected effects
Greater investment and income
Depreciation of the currency
Depreciation of the currency tends to expand net exports, reinforcing the
expansionary effect of an increase in the money supply.

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 Fiscal policy with flexible exchange
rates

Expansionary fiscal policy serves to increase

domestic income but also to increase interest
rates.

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 Fiscal policy with flexible exchange
rates

Expansionary fiscal policy serves to increase

domestic income but also to increase interest
rates.
The increase in interest rates tends to
appreciate the currency which contracts net
exports.
The contraction in net exports serves to offset the
expansionary effect of fiscal policy.
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 Policy summary

With fixed exchange rates, fiscal policy tends to

be more effective than monetary policy.
With flexible exchange rates, monetary policy
tends to be more effective than fiscal policy.

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 Direct controls

Note: the use of many controls (for instance,

tariffs and non-tariff barriers) is constrained by
international treaties such as the General
Agreement on Tariff and Trade (GATT).

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