The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability
“This orientation of monetary policy towards the external side of the economy has since developed into one of the most robust features of open economy macro-economics.” Andrew K. Rose
“Another key contribution of Mr Mundell is the elucidation of the assignment principle of economic policy making. This idea had originated in a work by Jan Tinbergen, but Mr Mundell was the first to lay down its principles and to successfully apply it to a concrete policy problem.” Economic Times
In countries where employment and balance-of-payments policies are restricted to monetary and fiscal instruments, monetary policy should be reserved for attaining the desired level of the balance of payments and fiscal policy for preserving internal stability. The opposite system would lead to a progressively worsening unemployment and balance-of-payments situation.
The explanation can be related to what I have elsewhere called the principle of effective market classification: Policies should be paired with the objectives on which they have the most influence. If this principle is not followed, there will develop a tendency either for a cyclical approach to equilibrium or for instability.
The incorrect use of fiscal policy for external purposes and monetary policy for internal stability violates the principle of effective market classification, because the ratio of the effect of the rate of interest on internal stability to its effect on the balance of payments is less than the ratio of the effect of fiscal policy on internal stability to its effect on the balance of payments.
On a still more general level, we have the principle that Tinbergen has made famous—that to attain a given number of independent targets there must be at least an equal number of instruments. Tinbergen’s principle is concerned with the existence and location of a solution to the system. It does not assert that any given set of policy responses will, in fact, lead to that solution. To assert this, it is necessary to investigate the stability properties of a dynamic system. In this respect, the principle of effective market classification is a necessary companion to Tinbergen’s principle.