If a sustainable constant economic growth rate is desired, then full employment and a stable price level is paramount. Economic authorities in general agree that a current account deficit is possible to maintain, but as to how large this deficit can healthily become is debatable. If a deficit is too large, it may cause problems if a country foresees difficulties in repaying its debts.
In this question, we are focusing on whether or not expenditure must be altered to achieve internal and external balance within the economy. To evaluate this, we must look at fiscal policy and the obstacles encountered in policy planning. If government orders fixed exchange rates, the monetary authority of a country is forced to keep exchange rates constant. This however, means that they cannot act unilaterally to bring about balance. Under these conditions, the fiscal authority has to stand alone in attempts to create internal and external balance. The diagram below demonstrates the obstacles to fiscal planners. It is clear that fiscal policy cannot by itself bring about both internal and external balance, but merely one and the other.
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If a country were experiencing over employment and an excessive current account surplus, this would imply that the country is located in area A on the above graph. Here policy makers are faced with two decisions. Firstly, they could use expansionary fiscal policy to attain external balance or secondly, they could use contractionary fiscal policy to achieve internal balance. Either way however, attaining one balance will bring the economy further away from the other balance, as can be seen in the following diagram. .
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If an expansionary policy were chosen because of greater government spending or lowering taxes, the DD curve shifts to the right. This however, would put pressure on the exchange rate to appreciate (because of higher domestic interest rates). Monetary authorities would have to purchase foreign assets and therefore cause a shift of the AA curve to the right.
