In an open economy setting, policymakers need to achieve two goals of macroeconomic stability, viz. internal and external balances. Internal balance is a state in which the economy is at its potential level of output, i.e., it maintains the full employment of a country’s resources and domestic price levels are stable.
External balance is attained when a country is running neither excessive current account deficit nor surplus (i.e., net exports are equal or close to zero). Attaining internal and external balances requires two independent policy tools (also see Swan diagram). One is expenditure changing policy and the other is expenditure switching policy.
Expenditure changing policy aims to affect income and employment with the goal of equating domestic expenditure or absorption and production and takes the form of fiscal or monetary policy. Expenditure switching is a macroeconomic policy that affects the composition of a country’s expenditure on foreign and domestic goods. More specifically it is a policy to balance a country’s current account by altering the composition of expenditures on foreign and domestic goods (see Balance of payments account). Not only does it affect current account balances, but it can influence total demand, and thereby the equilibrium output level.