Introduction
In an open economy, a country must maintain both internal balance (full employment and price stability) and external balance (a sustainable current account or balance of payments). Under a flexible exchange rate regime, the exchange rate is determined by market forces without direct government intervention. This system helps adjust the balance of payments and plays a crucial role in maintaining macroeconomic stability. In this answer, we’ll explore how internal and external balance is achieved under flexible exchange rates.
Internal and External Balance Defined
- Internal Balance: Refers to full employment of resources and stable inflation within the country.
- External Balance: Refers to a balance of payments position that is sustainable in the long term (i.e., no large deficits or surpluses).
Flexible Exchange Rate: Overview
Under a flexible exchange rate system:
- Exchange rate is determined by demand and supply in the foreign exchange market.
- Government does not fix or peg the currency.
- Currency value appreciates or depreciates based on trade flows, capital movements, and expectations.
Mechanism for Achieving Internal and External Balance
1. Exchange Rate as a Self-Correcting Tool
- If a country has a balance of payments deficit (imports > exports), demand for foreign currency increases, and its own currency depreciates.
- Depreciation makes exports cheaper and imports costlier, improving trade balance.
- Over time, the deficit is corrected automatically.
2. Impact on Aggregate Demand and Internal Balance
- Currency depreciation boosts exports and reduces imports → net exports rise → aggregate demand increases.
- This leads to higher output and employment, improving internal balance (especially during recession).
- Conversely, if there’s overheating (high inflation), currency appreciation reduces net exports and cools down the economy.
3. Capital Flows and Interest Rates
- Under flexible rates, capital flows are sensitive to interest rate differentials.
- If domestic interest rates rise, capital inflow increases → currency appreciates.
- This appreciation reduces net exports, moderating aggregate demand and prices.
4. Role of Monetary Policy
- With flexible exchange rates, countries have autonomy in using monetary policy to maintain internal balance.
- For example, during inflation, central banks can raise interest rates to reduce money supply and demand.
- Exchange rate adjusts in the background to maintain external balance.
Mundell-Fleming Model Explanation
The Mundell-Fleming model explains this adjustment in an open economy using IS-LM-BP curves.
- Under flexible exchange rates, the BP curve (balance of payments) shifts automatically with exchange rate changes.
- Expansionary fiscal policy increases output but may lead to a deficit → depreciation → boosts net exports → supports growth.
- Expansionary monetary policy lowers interest rates → capital outflow → depreciation → increases exports → boosts demand and employment.
Advantages of Flexible Exchange Rates
- Automatic correction of external imbalances through currency adjustments.
- Freedom to use monetary policy for domestic goals (employment, inflation).
- No need to maintain large foreign exchange reserves.
Limitations
- Exchange rates may be volatile due to speculation and capital flows.
- Depreciation may lead to imported inflation (costlier imports).
- Short-term capital movements may disrupt the adjustment process.
Conclusion
Under a flexible exchange rate system, internal and external balances are maintained primarily through market-driven exchange rate adjustments. Depreciation helps correct deficits and stimulate demand, while appreciation can cool an overheating economy. The system provides countries with the freedom to pursue independent monetary policies and acts as a natural stabilizer. However, this mechanism works best when markets function efficiently, and economic agents respond predictably to changes in prices and exchange rates.