relationship between the internal value of money and the external value of money

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1. Government Macro‑Economic Objectives (Syllabus 10.1)

Cambridge A‑Level Economics expects students to recognise that governments usually pursue the following six objectives. These objectives can conflict, so understanding their inter‑relationships is essential.

  • Price stability (low inflation)
  • Full employment (low unemployment)
  • Economic growth (rising real GDP)
  • Balance‑of‑payments equilibrium
  • Sustainable development (environmental sustainability and inter‑generational equity)
  • Equitable distribution of income (redistribution)

2. Internal and External Values of Money

2.1 Internal Value of Money

The internal value is the amount of domestic goods and services that one unit of currency can purchase – the inverse of the domestic price level.

  • Higher internal value ⇔ Lower price level (deflationary pressure).
  • Lower internal value ⇔ Higher price level (inflationary pressure).

Quantity Theory of Money (QTM) provides the core relationship:

\[ M \times V = P \times Y \]
  • M – money supply
  • V – velocity of money (average number of times a unit of money is spent in a year)
  • Y – real output (real GDP)
  • P – price level (inverse of internal value)

Quantitative example: If \(M = £800\) billion, \(V = 4\), and \(Y = £2{,}000\) billion, then

\[ P = \frac{M \times V}{Y} = \frac{800 \times 4}{2{,}000}=1.6 \] The internal value of £1 is therefore \(1/P = 0.625\) units of real output.

2.2 External Value of Money

The external value is the amount of foreign currency that one unit of domestic currency can buy, expressed by the nominal exchange rate (\(E\)).

  • Appreciation ⇔ Higher external value (domestic currency buys more foreign currency).
  • Depreciation ⇔ Lower external value (domestic currency buys less foreign currency).

Key determinants:

  • Relative price levels – Purchasing Power Parity (PPP) \[ E = \frac{P_{\text{domestic}}}{P_{\text{foreign}}} \]
  • Interest‑rate differentials – Interest Rate Parity (IRP) \[ (1+i_{\text{domestic}}) = (1+i_{\text{foreign}})\,\frac{E^{e}}{E} \] where \(i\) = nominal interest rate and \(E^{e}\) = expected future exchange rate.
  • Capital flows, expectations, and speculative activity.

3. Five‑Link Framework (Syllabus 10.2)

The Cambridge syllabus requires students to explain five specific inter‑relationships between the macro‑economic problems. The links are numbered exactly as in the syllabus.

Link Direction of Influence Key Economic Mechanism
Link 1 – Internal ↔ External Value of Money
Higher domestic inflation → higher \(P_{\text{domestic}}\) Depreciation of the currency (PPP) Exchange‑rate adjusts to restore relative purchasing power.
Currency depreciation → higher import prices Domestic inflation rises (import‑price pass‑through) Feedback loop between external and internal values.
Link 2 – Inflation ↔ Unemployment (Phillips Curve)
Expansionary demand → higher output & lower unemployment Short‑run rise in inflation Traditional downward‑sloping Phillips curve.
Higher inflation expectations Shift of the Phillips curve upward; trade‑off disappears Adaptive or rational expectations.
Link 3 – Inflation ↔ Balance of Payments
Higher domestic inflation → depreciation (PPP) Exports become cheaper, imports more expensive → potential current‑account improvement Terms‑of‑trade effect may be offset by “inflation‑induced” loss of competitiveness.
Link 4 – Growth ↔ Inflation
Rapid real‑GDP growth → upward pressure on aggregate demand Higher price level if the economy approaches full capacity AD/AS framework – right‑ward shift of AD intersecting an upward‑sloping SRAS.
Link 5 – Growth ↔ Balance of Payments
Higher growth → higher import demand Worsening current account unless export growth matches “Twin‑deficit” hypothesis (budget deficit → higher growth → larger import bill).

4. How the Links Operate in the AD/AS Framework

  • Internal value (price level) is represented on the vertical axis of the AD/AS diagram. A rise in \(P\) moves the economy up along the SRAS curve.
  • External value (exchange rate) influences the net‑export component of Aggregate Demand:
    • Depreciation → rightward shift of AD (higher X, lower M).
    • Appreciation → leftward shift of AD.
  • Monetary or fiscal expansion shifts AD right; if the economy is near full employment this creates inflationary pressure (higher \(P\)) and, via PPP, a depreciation that partially offsets the AD shift.

5. Policy Toolbox (Syllabus 10.3)

Policy Tool Target Objective(s) Typical Mechanism Potential Trade‑off / Government Failure
Expansionary fiscal policy (higher G or lower T) Growth, lower unemployment Increases AD → higher output and price level. May worsen the current account (higher imports) and fuel inflation; crowding‑out if financed by borrowing.
Contractionary fiscal policy (lower G or higher T) Price stability Reduces AD → lower price level. Can raise unemployment; political resistance (Laffer‑curve effects).
Expansionary monetary policy (lower i, QE) Growth, lower unemployment Raises money supply → lower interest rates → higher investment & consumption; may depreciate the currency. Liquidity trap, long time‑lag, possible asset‑price bubbles.
Contractionary monetary policy (higher i) Price stability Reduces investment & consumption; can appreciate the currency. Higher unemployment; may attract speculative capital inflows that over‑appreciate the currency.
Supply‑side policies (deregulation, training, R&D subsidies) Long‑run growth, lower structural unemployment Shift LRAS right, improve productivity. Long implementation lag; benefits may be unevenly distributed (equity issue).
Exchange‑rate policy (fixed, managed float, devaluation) Balance‑of‑payments, export competitiveness Directly alters external value of money. Risk of speculative attacks; loss of monetary‑policy autonomy under a fixed regime.
Trade policy (tariffs, quotas, export subsidies) Current‑account improvement, protection of domestic industries Alters relative prices of imports and exports. Retaliation, dead‑weight loss, may dampen growth.
Income‑distribution policies (progressive tax, welfare) Equitable distribution, social stability Re‑allocates disposable income. Potential disincentive effects on labour supply; fiscal cost.
Environmental / sustainability policies (carbon tax, green subsidies) Sustainable development Internalises externalities; may shift LRAS left in the short run, right in the long run. Short‑run cost to firms/consumers; political resistance.

5.1 Government Failure – A Quick Reference

Government failure occurs when policy actions do not achieve the intended objective or create additional problems. The most common sources are:

  • Implementation lag – time between decision and impact (especially for fiscal and supply‑side measures).
  • Political pressure / rent‑seeking – policies shaped by special interest groups rather than efficiency.
  • Information problems – policymakers lack accurate data on the size of the multiplier, the elasticity of imports, etc.
  • Policy coordination failure – monetary and fiscal authorities pursue conflicting goals.
  • Externalities and spill‑overs – e.g., a subsidy that raises domestic output but worsens the trade balance.

6. Expanded Summary Table (Internal vs. External Value of Money)

Aspect Internal Value of Money External Value of Money Macro‑Economic Implications
Definition Purchasing power of the currency at home ( \(1/P\) ) Nominal exchange rate (foreign currency per unit of domestic currency, \(E\)) Determines the domestic price level and international competitiveness.
Key Determinants Money supply (M), velocity (V), real output (Y) Relative price levels (PPP), interest‑rate differentials (IRP), capital flows, expectations Policy levers often affect both simultaneously.
Effect of Inflation ↓ Internal value (higher P) ↓ External value (depreciation, \(E\) rises) Worsens the current account; may trigger tighter monetary policy; real wages fall → possible rise in unemployment.
Effect of Monetary Tightening ↑ Internal value (lower P) ↑ External value (appreciation, \(E\) falls) Reduces inflation, but can raise unemployment and improve the capital‑account balance.
Effect of Expansionary Fiscal Policy ↓ Internal value (higher P via AD shift) ↓ External value (depreciation if price‑level effect dominates) Boosts output and employment; risk of a larger import bill → current‑account deficit.
Effect of Supply‑Side Policies Potential ↑ internal value (lower P) in the long run as LRAS shifts right Neutral short‑run; may lead to appreciation if growth outpaces inflation. Higher potential output, lower structural unemployment, but long implementation lag.
Sustainability / Development Policies Environmental taxes raise the price of polluting goods (lower internal value for those goods) May cause short‑run depreciation if taxes reduce investor returns; long‑run green‑technology gains can improve competitiveness. Balances growth with environmental quality; can affect trade patterns (e.g., carbon‑border adjustments).

7. Illustrative Example – United Kingdom (2022‑23)

  • Domestic inflation rose to 10 % while the pound‑euro rate moved from £0.85/€ to £0.80/€ (a 5.9 % depreciation).
  • Using PPP: \[ \frac{P_{\text{UK}}}{P_{\text{Eurozone}}} \approx \frac{1.10}{1.00}=1.10 \;\Rightarrow\; E_{\text{expected}} \approx 0.85 \times 1.10 = 0.935 \] The observed £0.80/€ indicates additional factors (e.g., capital‑flow pressures) beyond pure PPP.
  • The weaker pound raised import prices, feeding a second‑round inflationary effect – a classic feedback loop between external and internal values.
  • Higher import prices widened the current‑account deficit, illustrating Link 3 (Inflation ↔ Balance of Payments).
  • The Bank of England responded with a series of rate hikes (contractionary monetary policy) aiming to:
    • Lower the price level (restore internal value).
    • Support an appreciation of the pound (restore external value).

8. International Economic Issues (Syllabus 11.1‑11.5)

These topics are part of the A‑Level specification but are outside the scope of this particular set of notes. Students should consult the textbook chapter on “International Economic Issues” for coverage of:

  • Trade‑related development strategies, foreign aid, and debt relief.
  • Globalisation, multinational enterprises, and the role of the WTO.
  • Exchange‑rate regimes and the “impossible trinity”.
  • Balance‑of‑payments components and sustainability of external deficits.
  • Economic development, poverty, and inequality in the global context.

9. Exam‑Focus Box (AO Weightings & Mark Allocation)

Assessment Objectives (AOs)
  • AO1 – Knowledge & Understanding: 30 % of total marks.
  • AO2 – Application: 25 %.
  • AO3 – Analysis: 25 %.
  • AO4 – Evaluation: 20 %.
Five‑Link Requirement
Paper 4 (macro‑economics) always includes a question that asks candidates to “explain the links between the macro‑economic problems”. The answer must:
  1. Identify the correct link (1‑5).
  2. State the direction of influence.
  3. Explain the underlying mechanism (e.g., PPP, AD/AS, Phillips curve).
  4. Provide a brief evaluation (short‑run vs long‑run, possible policy trade‑offs).
Typical mark allocation: 6‑8 marks per link, with 2 marks for identification, 2 marks for mechanism, and 2‑4 marks for evaluation.

10. Suggested Diagrams for Revision

  • AD/AS diagram showing a right‑ward AD shift (expansionary policy) → higher \(P\) (lower internal value) and the resulting depreciation on a separate PPP diagram.
  • Phillips‑curve diagram (short‑run downward‑sloping, with an expectations‑augmented upward shift).
  • Five‑link flowchart linking inflation, unemployment, growth, balance of payments, internal value, and external value.
  • Circular‑flow diagram illustrating how changes in internal value affect external value, which in turn influence inflation, unemployment and the current account.

11. Key Takeaways

  • The internal and external values of money are inter‑dependent; a change in one inevitably influences the other through price‑level and exchange‑rate mechanisms.
  • All six government objectives are linked via the five‑link framework; achieving one goal can undermine another.
  • Policy tools have primary targets but also side‑effects; understanding the underlying mechanisms (AD/AS, PPP, IRP, Phillips curve) is essential for evaluating effectiveness and anticipating government failure.
  • For A‑Level exams, students must be able to:
    • Define internal and external values of money and state their determinants.
    • Explain each of the five links with appropriate diagrams.
    • Assess the likely impact of fiscal, monetary, supply‑side, exchange‑rate and trade policies on the whole economy.

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