Page 219 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

Suppose that the country chooses to use only monetary policy, and adopts a contractionary monetary Notes
policy to correct its BOP deficit. The use of a contractionary monetary policy makes its original LM
schedule (LM ) shift leftward to LM intersecting schedule EB at point F. Now all the three schedules,
3 1
EB, LM and IS , intersect at point F. Point F is therefore the point of internal and external balance.
1
1
The BOP deficit is totally eliminated. But the country has to pay a high cost in terms of fall in the
national income from OY to OY and a rise in the interest rate from Or to Or . It means that the BOP
1 0 1 2
deficit is eliminated at the cost of decrease in national income and increase in unemployment. This is,
of course, a heavy cost of eliminating the BOP deficit.
Let us now look at the effects of fiscal policy in isolation. When a country decides to use only fiscal
policy to eliminate its BOP deficit, it will have to use an expansionary fiscal policy. To begin the
analysis, let us suppose that the economy is in equilibrium at point E with BOP deficit and the
government uses expansionary fiscal policy. The use of an expansionary fiscal policy shifts the original
IS schedule from IS to IS which intersects with schedules EB and LM at point H. All the three
1 3 3
schedules, EB, LM and IS , intersect at point H. Point H is, therefore, the point of internal and external
3
3
balance. The BOP deficit is totally eliminated. What are the other consequences ? The level of national
income increases from OY to OY and interest rate increases from Or to Or . This increase in national
1 3 1 4
income and interest rate has a very high inflationary potential. It means that the BOP deficit is
eliminated at the risk of high potential inflation. Inflation involves high economic and social costs.
This solution may therefore not be socially and politically desirable.
Let us now examine the effect of monetary-fiscal mix. When the government decides to use a policy-
mix, it will have to adopt a contractionary monetary policy combined with an expansionary fiscal
policy. A policy-mix approach requires using an expansionary fiscal and a contractionary monetary
policy. The expansionary fiscal policy shifts schedule IS to IS and contractionary monetary policy
1 2
shifts schedule LM to LM . In Figure 19.3, schedules IS , LM and EB intersect at point G. Point G is
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3
2
2
therefore the point of internal and external balance. This solution is comparatively better and preferable
as it mitigates the disadvantages of both monetary and fiscal policies used separately. Unlike monetary
policy, it does not cause unemployment and decrease the level of income, and unlike fiscal policy, it
does not create conditions for hyper inflation though some inflation will be there. A policy mix
approach is, therefore, preferable to other options available to the country.
Assignment Dilemmas in Policy Mix
The use of monetary-fiscal mix in not as simple and straightforward as concluded above. The choice
and implementation of monetary-fiscal mix is a complex problem in the real world. Complexity
arises on account of the following two factors.
(i) Lack of Perfect Knowledge and Accurate Data : The policy makers, in general, do not have
perfect knowledge about the shape and place of the IS and LM schedules. Nor do they have
complete and accurate data about the economic variables used in the IS-LM model. The policy-
makers have data, often inaccurate, only on national income, unemployment, inflation, interest
rate and balance of payments. This is just not sufficient to determine the shape, slope and place
of the IS and LM curves. Therefore, it is immensely difficult to formulate an optimum monetary-
fiscal mix. Besides, what is largely unknown and unpredictable—but a crucial requirement in
the formulation of an appropriate monetary-fiscal mix—is the possible outcome of interaction
between the monetary and fiscal policies. It is therefore, extremely difficult to adjust the monetary
and fiscal levers to find an optimal combination of monetary-fiscal policy mix.
(ii) Disagreement on the Role and Effectiveness of Monetary and Fiscal Policies : As discussed
earlier, the economists disagree on the role and effectiveness of monetary and fiscal policies.
The disagreement on the role and effectiveness of monetary and fiscal policies and the ensuing
a prolonged debate has created more confusion rather than providing guidelines for finding an
appropriate policy mix. The final choice is then made on the political and ethical grounds which
conflict often with economic goals.
The nature and the classification of problems involved in policy choice is illustrated in
Figure 19.4. The schedule EB is the same as in Figure 19.3. It represents the path of external
balance. The vertical line, IB, represents the path of internal balance. It is drawn through the

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