Foreign Exchange: Internal & External Balances

Discuss the concepts of internal and external balances and what floating exchange rates can do to a country's economy

Review of the subject

When referring to the internal balance these are the goals of economics relating to full employment or a case of normal production and low inflation, that is, the prices are stabilized. In the situation of over-employment the prices of materials increase while in the case of under-employment the prices will decrease. When unexpected inflation occurs, the country finds it difficult to plan for the future and there is a case of income redistribution between traders and investors. The external balances relate to equilibrium in the balance of trade. This signifies the balance between the country’s current and capital accounts. External balances occur when the payment transactions involved induces balance of trade to zero (Anonymous, 1870-1973). Floating exchange rate is the case where the countries’ currency is determined by the foreign-exchange market through supply and demand on the Forex market. In this case the value of the currency, also called floating currencies, changes depending on the foreign exchange market (McBrewster ‘et al’, 2010).

Discussion

History has proven that it is not possible for a country to maintain the internal and external balances which comes from the argument that countries with low labor productivity cannot maintain stable price levels. The problem of low growth rate, the labor productivity sector, and poor foreign trade relations lead to increased external imbalance. The competition between home product demand and commodity export also leads to increased imbalance. It is evident that increased labor productivity results to increased economic growth and that through export of commodities there is a positive labor productivity growth. The issue concerning money equilibrium affects the internal and external balances of trade (Columbus, 2004).

Exchange rate refers to the price of a currency in relation to another. In the floating exchange rate these prices are determined by the foreign market which fluctuates occasionally. The floating exchange rates have a great impact on a country’s economy and this might trigger its stability or instability. There is an automatic adjustment in case a country has a larger payment deficit which leads to continuous currency outflow from the country. Floating exchange rate allows the government to determine the interest rates and this allows the economy to expand as the country will be charging interests depending on the currency price. Since the currency changes randomly, the exchange rates also vary from time to time and therefore it can lead to a point of economic instability (McBrewster ‘et al’, 2010).