Floating Exchange Rates Internal Balance

Floating Exchange Rates

Internal balance within an economy refers to an equilibrium state wherein the country is able to maintain full employment and price stability. External balance refers to the current account, which if balanced would run neither a surplus nor a deficit. The internal balance is comprised of consumption, investment spending, government spending and the current account. These functions come together to produce the GDP. Internal balance is achieved when output is at the full employment level. The external balance is comprised solely of the current account, which itself is a component of the internal balance.

In reality, neither condition is likely to be sustained. However, policymakers can make adjustments to attempt to bring both the internal and external balances into equilibrium. This requires a combination of monetary and fiscal policy. Floating exchange rates are critical to the use of the former.

What a floating exchange rate gives a country that a fixed exchange rate regime does not is the ability to adjust prices within the economy and the ability to make adjustments to the current account. In a fixed rate regime, the government can make spending decisions (fiscal policy) that can impact the level of aggregate demand in the nation. Compared with a floating rate regime, this is a weak form of control. Government is only controlling one element of demand -- and in many economies government should not be the biggest driver of demand in an economy.

In a floating exchange rate regime, the government can control the level of aggregate demand by adjusting exchange rates, which can be done either by buying or selling currency (open market operations) or through interest rate adjustments, or using both tactics. The exchange rate is one of the key drivers of the external balance in an economy. As a company's products become more expensive on world markets, demand for those products will decline. If a country's products become cheaper on world markets, demand can be expected to increase. By adjusting the exchange rate, governments can therefore adjust the current account, impacting both on external and internal balance.

In addition, floating exchange rates may also give the government some flexibility with respect to the consumption function. The current issue with Greece and the euro illustrates this. Greece needs to spur economic growth in order to build a current account surplus that will help it to pay off its debt. In a floating exchange rate regime, Greece could do this by reducing the value of its currency, making Greek exports cheaper on world markets. This would bring in the necessary foreign capital. The Greek government, however, does not have control over its exchange rate as a member of the Eurozone. As such, it has no such flexibility to spur export growth. Indeed, Greek products are overpriced on the world market because costs in Greece are out of line with its economy. Although the euro is a floating currency, for the Greek government it is not because it cannot exert any real control over its movements. Thus, Greece is stuck with a high exchange rate that prohibits export growth, leaving the entire external and internal economy out of equilibrium. As a result, the Greek economy is not going to have full employment any time soon. Indeed, because the crisis has been spurred by government debt, the government cannot increase spending to prop up domestic demand. Greece, by virtue of not having a currency whose float it can control, now lacks its two most powerful policy levers and therefore is powerless to bring its internal economy into balance.