Assume Nation A operates under a flexible exchange rate system, the principle of imperfect
capital mobility and desires to achieve both internal and external balance.
a) Which macroeconomic policy should Nation A use to simultaneously achieve internal
and external balance and why?
Nation A should use a combination of fiscal and monetary policy to achieve both internal
and external balance.
Fiscal policy can be used to achieve internal balance by adjusting government spending
and taxation to combat inflation or unemployment. For example, if Nation A is
experiencing high inflation, the government can reduce spending or increase taxes to
cool down the economy. On the other hand, if there is high unemployment, the
government can increase spending or reduce taxes to stimulate the economy.
Monetary policy, on the other hand, can be used to achieve external balance by
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adjusting interest rates and money supply to affect the exchange rate. If Nation A is
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• Not to duplicate,
experiencing a trade deficit, the
reproduce central
and/or bank can
misrepresent the raise interest
contents rates to as
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capital and strengthen the currency. Conversely, if there is a trade surplus, the central
bank can lower interest rates to discourage capital inflows and weaken the currency.
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