International Economics 8th Edition by Dennis Appleyard, Alfred Field

Exercise 2

If the economy is operating at c in Figure, what policy actions should be carried out to reach the internal balance target? Why?
FIGURE Internal Balance, External Balance, and Policy Instrument Classification
in a Mundell-Fleming Diagram

The IB curve reflects all combinations of interest rates i (monetary policy) and net government spending ( G ? T) that lead to the attainment of domestic targets, that is, internal balance. Similarly, the flatter EB curve reflects all combinations of i and ( G ? T) that generate equilibrium in the balance of payments for a given exchange rate. Points above the IB curve reflect unacceptably high unemployment, and points below reflect unacceptably rapid inflation. Similarly, points above the EB curve represent a surplus in the balance of payments, and points below represent a deficit. It is clear that internal balance and external balance are obtained simultaneously only at i * and ( G ? T) *. Finally, if the economy is not at i * and ( G ? T) *, monetary policy should be pursued to reach external balance and fiscal policy to reach internal balance.