External Balance and Internal Balance:External balance refers to achieving equilibrium in the balance of payments.

Internal balance refers to achieving full employment with price stability.

Generally a country assigns a priority to maintain internal balance by maintaining
full employment level of employment and price stability. But when a country
witnesses persistently fundamental or structural deficit in the balance of payments
the concerned country has to switch over its priority from maintaining internal
balance to maintaining external balance.
The cyclical or seasonal type of disequilibrium in the balance of payments is a
transitory phenomenon which can be reversed or corrected automatically while it is
not the case with regard to structural or fundamental disequilibrium in the balance
of payments especially when it persists for a long time. Then it gets transformed
into a chronic phenomenon. Hence it is the fundamental disequilibrium in the
balance of payments that needs adjustment.
When a country has several objectives to be achieved the country is bound to use
several policy instruments. Hence the problem of Assignment comes into being. The
problem of pairing targets and instruments gets referred to as the problem of
Assignment. The Assignment problem is a problem of assignment of policy
instruments to achieve the targets.

EXPENDITURE CHANGING POLICIES The expenditure

changing policies are referred to as the expenditure adjustment policies. The
expenditure change or adjustment can be brought about either by reducing or
increasing the expenditure. The expenditure changing policies bring about changes
in income. Thus the expenditure changing policies can also be called as income
changing policies. The deficit in the balance of payments arise due to increase of
imports and decrease of exports or both. To curtail imports you must curtail your
expenditure. Hence expenditure reducing policy pertains to correcting the deficit in
the balance of payments. On the other hand expenditure increasing policy pertains
to correct the surplus in the balance of payments. By following the expenditure
increasing policy you can increase your imports thereby it reduces your surplus
balance of payments. Out of deficit and surplus balance of payments it is the deficit
in the balance of payments which becomes a more serious problem to deal with.
Hence the expenditure changing policy goes with the name of expenditure reducing
policy. The monetary and fiscal policies are used to bring about reduction in
expenditure to cure deficit in the balance of payments.
MONETARY POLICY
The monetary policy is the policy of the monetary authority of the country. The
monetary authority of the country is the Central Bank of the country. In case of
India, the Reserve Bank of India is the Central Bank of India. The monetary policy
deals with the monetary management ie controlling the supply of money and credit
of the economy through the use of monetary instruments. The central bank of the
country has got so many instruments at its disposal to control the quantum of
money and credit of which two are very important viz i) Bank Rate and ii) Open
Market Operations.
Bank Rate is an official minimum rate of the Central Bank of the country at which it
advances short term loans to commercial banks. The Bank Rate policy means
raising or lowering down of the bank rate depending upon the situation.
Open market operations mean buying or selling of the Government securities in the
open market.
The Bank Rate and open market operations go hand in hand.
The Central Bank of the country follows two types of monetary policy Viz.
i) Contradictory monetary Policy and
ii) d

The contradictory monetary Policy is also called as tight monetary Policy. When a
country suffers from deficit in the balance of payments it follows tight monetary
policy. It raises the bank rate. When the bank rate is raised by the Central Bank the
commercial bank finds it very difficult to get short term advances from the central
bank because loan from central bank becomes costlier. There is generally a 2%
difference between the bank rate and market rate. The market rate is a rate which
is charged by the commercial banks to their customers for advancing loans. When
there is a hike in the market rate of interest getting loans from commercial banks
becomes costlier for the banks customers which curtails money supply.
Simultaneously the central bank of the country sells Government. securities in the
open market. Those who buy the securities issue cheques to the Central Bank on
their accounts with the commercial bank. The central bank thus withdraws cash
from the commercial bank which controls their habit of creation of multiple credit.
Thus the central bank of the country by following tight monetary policy reduces
money supply which leads to reduction in expenditure which in turn reduces imports
and thus ultimately brings about improvement in the balance of payments. (The
increase in the rate of interest will lower down investment) In case of surplus
balance of payments the central bank follows easy monetary policy in which the
rate of interest gets lowered down which leads to increase in investment and
income which increases imports. In case of tight monetary policy due to hike in rate
of interest the inflow of foreign capital takes place which also renders a helping
hand to correct the deficit in the balance of payments. Conversely when the central
bank follows easy money policy the rate of interest falls which leads to flight of
capital from the concerned country to foreign countries which renders a helping
hand to correct surplus balance of payments.
Monetary policy also helps to maintain internal balance. When the central bank
follows easy money policy the rate of interest is lowered down. It accelerates
investment which leads to generation of income and employment through
multiplier. It leads to rise in price level. Thus easy money policy of the central bank
maintains internal balance through maintenance of full employment and price
stability. The vice versa situation takes place when the central bank follows tight
money policy.
Fiscal Policy:The fiscal policy is also used as an instrument of maintaining both internal and
external balance. The term fiscal is derived from the Greek word fisc which means
basket. The Governments basket is its treasury. Thus fiscal policy is the policy of
the Government wi+++th regard its treasury. It is also called as Budgetory Policy
of the Government which deals with revenue and expenditure of the Government ie
the public bodies. According to Arthur Smithies fiscal policy is a policy under which
the Government. uses its revenue and expenditure in such a way as to produce

desirable effects avoiding undesirable effects on the national economy as regards

production, income, employment and balance of payments. Fiscal Policy uses two
very import fiscal tools to bring about defined changes i.e. to maintain internal and
external balance viz taxation and expenditure like monetary policy fiscal policy is
also of two types viz.
i) Contractionary fiscal Policy and
ii) Expansionary fiscal Policy.
To reduce deficit in the balance of payments the Government follows concretionary
fiscal policy. On the one hand Government reduces public expenditure and on the
other hand Government raises tax rates of both the direct taxes and indirect taxes.
The reduction in Government. expenditure will reduce income and employment
through multiplier in the reverse gear which will also reduce price level. It will
control inflation and will maintain internal balance. It is also called as an antiinflationary fiscal policy. It will also maintain external balance by improving balance
of payment situation of a country. By reducing income it will reduce imports
because import is a function of income. M = f (Y) There is a positive and direct
relationship between income and imports. When income decreases it brings about a
corresponding decrease in imports. By decreasing prices of goods and services, our
country becomes a good country for the foreigners to buy the things from and
hence exports accelerate leading to increase in export earning which leads to
improvement in balance of payments.
An expansionary fiscal policy is followed when the country would like to reduce
surplus in the balance of payments. The Government. expenditure increases and
the tax rates of both direct and indirect taxes are reduced. It leads to increase in
income and employment through multiplier effect. It leads to increase in
consumption, price level also rises. A country becomes a very good country for the
foreigners to sell their goods into the reporting country. Thus imports accelerate
while exports contract and as such the surplus in the balance of payments get
reduced. Thus a country maintains external balance. It also maintains internal
balance of maintaining employment income and price level to equilibrium position.
However monetary policy is preferred for maintaining external balance while fiscal
policy is preferred for maintaining internal balance. Since expenditure reducing
policy brings about a positive effect on balance of payments while expenditure
increasing policy brings about a negative effect on balance of payments the
expenditure changing policy gets colored by its bright side ie the expenditure
reducing policy.