Internal balance

What Is Internal Balance?

Internal balance, within the field of macroeconomics, refers to a desirable state where a country's economy achieves full employment and price stability simultaneously. This means that all available labor resources are efficiently utilized, and there are no significant inflationary pressures or excessive unemployment. Achieving internal balance is a fundamental goal for economic policymakers as it signifies an economic equilibrium where aggregate demand matches aggregate supply, allowing for sustainable economic growth.³⁵,³⁴,³³

History and Origin

The concept of internal balance emerged as a core objective in macroeconomic policy discussions, particularly with the development of open-economy models in the mid-20th century. Economists recognized that managing a national economy involved not only domestic considerations but also its interactions with the global financial system. The distinction between internal and external objectives became clearer with the work of economists like James Meade and Trevor Swan. Meade, a Nobel laureate, extensively explored how countries could simultaneously achieve domestic objectives, such as full employment, and external objectives, like balance of payments equilibrium. His seminal work, The Balance of Payments (1951), laid foundational groundwork by discussing various policy combinations to reconcile "internal balance" with "external balance."³²,³¹ Later, Australian economist Trevor Swan formalized these ideas in his 1956 "Swan Diagram," which graphically illustrated the combinations of domestic expenditure and exchange rates required to achieve both internal and external equilibrium. The analytical framework was further refined by IMF staff during the 1970s.³⁰ The Mundell-Fleming model, independently developed by Robert Mundell and J. Marcus Fleming in the early 1960s, also provided a crucial framework for understanding how monetary and fiscal policy affect an open economy, particularly in relation to achieving internal balance under different capital mobility and exchange rate regimes.²⁹,²⁸

Key Takeaways

• Internal balance signifies an economy operating at full employment and with price stability.²⁷
• It is a primary macroeconomic policy goal, essential for sustainable economic growth and societal well-being.²⁶
• Policymakers use a combination of fiscal policy and monetary policy to manage aggregate demand and supply to achieve internal balance.²⁵,²⁴,²³
• An economy in internal balance efficiently utilizes its resources without excessive inflation or high unemployment.²²,²¹

Formula and Calculation

Internal balance is not represented by a single, universally accepted formula with discrete inputs that yield a quantifiable output. Instead, it is a conceptual state defined by two key macroeconomic conditions:

1. Full Employment: The economy is operating at its potential output (or natural rate of unemployment), meaning all available labor and capital resources are being utilized efficiently.
2. Price Stability: The rate of inflation is low and non-accelerating, preventing significant erosion of purchasing power or economic uncertainty.²⁰,¹⁹

While no direct formula calculates "internal balance," its achievement is often analyzed within larger macroeconomic models. For example, in a simplified Keynesian model, total output (Y) can be considered at a level consistent with full employment and stable prices. The components contributing to this output include:

$Y_f = C(Y_f - T) + I + G + CA(E \times P^*/P, Y_f - T; Y_f^* - T^*)$

Where:

• (Y_f) = Full-employment level of national income or potential output
• (C(Y_f - T)) = Consumption, which depends on disposable income ((Y_f - T))
• (I) = Investment
• (G) = Government Spending (a component of fiscal policy)
• (CA) = Current Account (influenced by the real exchange rate, domestic disposable income, and foreign disposable income)
• (E \times P^*/P) = Real exchange rate, where E is the nominal exchange rate, P* is the foreign price level, and P is the domestic price level.

This equation, when balanced at (Y_f) with stable prices, illustrates the aggregate components that contribute to the state of internal balance.

Interpreting the Internal Balance

Interpreting internal balance involves assessing the current state of an economy relative to its capacity and price stability goals. If an economy deviates from internal balance, it typically manifests as either:

• Unemployment and Low Inflation: This indicates that the economy is operating below its potential output, with underutilized resources and insufficient aggregate demand. Policies would generally aim to stimulate economic activity.
• High Inflation and Overheating: This suggests that demand exceeds the economy's productive capacity, leading to rising prices and potentially unsustainable growth. Policymakers would typically implement measures to cool down the economy.

A country is considered to be in internal balance when it successfully navigates these extremes, maintaining a delicate equilibrium. The objective is to achieve a level of economic activity that is neither too low (causing unemployment) nor too high (causing inflationary pressures).¹⁸ Policymakers constantly monitor economic indicators such as GDP growth, unemployment rates, and inflation figures to gauge the economy's proximity to internal balance.¹⁷

Hypothetical Example

Consider the fictional country of "Economia." For several years, Economia has experienced a stable 2% annual inflation rate and an unemployment rate of around 4.5%, which economists determine to be its natural rate of unemployment, consistent with full employment. The economy's output is consistently near its potential output, indicating that resources are being efficiently utilized.

Suddenly, a global economic downturn reduces external demand for Economia's exports. As a result, domestic industries face reduced orders, leading to layoffs and an increase in unemployment to 7%. At the same time, consumer spending decreases, and inflationary pressures subside, with inflation dropping to 0.5%. Economia is now experiencing an internal imbalance characterized by high unemployment and low inflation.

To restore internal balance, Economia's central bank could implement expansionary monetary policy by lowering interest rates to encourage borrowing and investment. Concurrently, the government could engage in expansionary fiscal policy by increasing infrastructure spending or cutting taxes to boost aggregate demand. These coordinated efforts aim to stimulate economic activity, reduce unemployment, and bring inflation back to the target range, thereby moving Economia back towards internal balance.

Practical Applications

Internal balance is a cornerstone of macroeconomic policymaking and finds practical application across various domains:

• Economic Policy Formulation: Governments and central banks actively design fiscal policy and monetary policy with the objective of achieving and maintaining internal balance. This involves managing aggregate demand to ensure efficient resource utilization and stable prices.¹⁶
• International Economic Relations: In an open economy, the pursuit of internal balance often intersects with the goal of external balance (equilibrium in the balance of payments). Economists frequently analyze these two objectives together, recognizing that policies aimed at one can impact the other. For instance, the Swan Diagram and Mundell-Fleming model provide frameworks for understanding these interactions.¹⁵
• IMF Programs and Surveillance: The International Monetary Fund (IMF) often assesses member countries' macroeconomic stability based on their progress towards internal and external balance. IMF programs may include policy recommendations designed to help countries achieve these objectives. The analytical framework used by the IMF for macroeconomic balance calculations defines internal balance as achieving the underlying level of potential output consistent with full employment and a low, sustainable rate of inflation.¹⁴,¹³
• Investment Decisions: A country's success in maintaining internal balance can influence investor confidence. Economies with stable prices and high employment are generally viewed as more attractive for investment due to reduced uncertainty and a more predictable economic environment.

Limitations and Criticisms

While internal balance is a crucial policy objective, its pursuit is not without limitations and criticisms:

• Difficulty of Simultaneous Achievement: Achieving full employment and price stability simultaneously can be challenging, especially in the face of supply shocks or structural issues within an economy. Policies designed to reduce unemployment might ignite inflation, while anti-inflationary measures could lead to higher unemployment in the short run. This trade-off is often represented by concepts like the Phillips Curve.
• Defining "Full Employment" and "Price Stability": The exact definitions of "full employment" (often tied to the non-accelerating inflation rate of unemployment, or NAIRU) and "price stability" can be ambiguous and subject to debate among economists. What constitutes an "optimal" level can vary.¹²,¹¹
• External Shocks: Open economies are susceptible to external shocks, such as changes in global demand, commodity prices, or international capital mobility. These shocks can disrupt domestic conditions and make maintaining internal balance significantly more difficult.
• Policy Lags: Fiscal policy and monetary policy operate with time lags, meaning the effects of policy interventions are not immediate. This can make it challenging for policymakers to react quickly and precisely to evolving economic conditions.
• Conflicting Objectives with External Balance: The pursuit of internal balance can sometimes conflict with the goal of external balance. For instance, a policy aimed at boosting domestic employment might lead to increased imports and a worsening current account deficit. As the Carnegie Endowment for International Peace highlights, understanding which country runs a corresponding external imbalance depends on institutional factors, making the simultaneous achievement of both balances complex.¹⁰ Furthermore, some analyses suggest that certain policy combinations may not always be sufficient to achieve both simultaneously, particularly in specific economic conditions.⁹

Internal Balance vs. External Balance

Internal balance and external balance are two distinct, yet interconnected, macroeconomic policy objectives for an open economy.

The key confusion between these terms arises because both are crucial for overall economic stability. However, internal balance looks inward at the domestic economy's performance, while external balance looks outward at its transactions with the rest of the world. Policymakers often face the challenge of finding the right combination of policies to achieve both objectives simultaneously.

FAQs

What does "internal balance" mean in economics?

Internal balance refers to a state in an economy where there is full employment of resources and stable prices, meaning low and non-accelerating inflation. It signifies that the economy is producing at its potential output without generating excessive unemployment or overheating.⁸,⁷

Why is internal balance important for an economy?

Internal balance is crucial for sustainable economic growth and overall societal well-being. When an economy is in internal balance, it avoids the detrimental effects of high unemployment (such as reduced output and social distress) and high inflation (such as erosion of purchasing power and economic uncertainty), creating a stable environment for investment and consumption.⁶,⁵

How do policymakers try to achieve internal balance?

Policymakers primarily use fiscal policy and monetary policy to manage aggregate demand and supply in the economy. Fiscal policy involves adjusting government spending and taxation, while monetary policy involves controlling interest rates and the money supply. By strategically using these tools, governments and central banks aim to move the economy towards a state of full employment and price stability.⁴,³

What happens if an economy is not in internal balance?

If an economy is not in internal balance, it will typically face either high unemployment or high inflation, or both, depending on the specific imbalance. High unemployment indicates underutilized resources and lost output, while high inflation erodes purchasing power and can lead to economic instability. Both scenarios represent a deviation from an optimal economic equilibrium.²,¹