Eurozone Exam Notes

7/31/2019 Eurozone Exam Notes

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Current Issues in the Eurozone

Cost benefits of membership in the euro area with

some application (apply to experience of somemembers). Discuss

Portone 2004

• January 1st 1999 € put into circulation.

• EMU created in 1993 with Maastricht.o Job of the EMU to ensure price stability - annual

inflation rate of less than 2 % result of that job was the euro.

• Move to a common currency for all EMU membershad both positive and negative consequences. Clearlythe benefits outweighed the costs, or the EMU would

not have adopted the euro. Benefits

• Most important benefit - elimination of the need toexchange currencies between EMU members.o Members of the EMU were expected to save as

much as $30 billion a year reduction in transaction costs associated

with the exchange of currency by firms thatimport or export to or from many countries.

problems with exchange rate volatility werealso eliminated between members.



only left fluctuations between the euro, thedollar, the yen, and any other importantnational currencies from outside the EMU.

Exchange rate fluctuations were another form of transaction cost, because they madetrading between firms from differentcountries more risky.

elimination of this risk will helpinternational trade, therefore, givingadvantages to all EMU countries.

• Two other major benefits of switching to the eurodeal with the prevention of competitive devaluationsand speculation.o A competitive devaluation is when one country

devalues its currency in order to export moregoods.

In response, the trading partners of thatcountry would do the same thing, resultingin a downward spiral regarding currencyvalue, as well as an increase in inflation.

goal of the EMU was to keep inflation rateslow, the switch to a single currency madesense.

o In terms of speculation, a single currency for thegroup of nations would eliminate speculation

between member nations. Speculation occurred regularly throughout

Europe because whenever people thought



that a currency was going to drop in value,they would sell all of their holdings in thattype of currency. Others would follow.

In order to control speculation Europeancountries had to keep interest rates high.

High interest rates hinder economies andthat was the result in Europe for a large partof the early nineties.

By eliminating speculation, the economiesof member countries would be allowed togrow much more easily than whenunnaturally high interest rates werenecessary to ward off speculation.

• Cutting out speculation and the risk of competitivedevaluation, as well as the need to convert from onecurrency to another, are all benefits that the European

Monetary Union counted on when switching to asingle currency.

Costs

• each member nation relinquished its right to changemonetary and economic policies in order to respondto economic problems at home

• exchange rates between countries were no longer adjusted by the individual countries to help regionaleconomic slumps get moving.

• Major costs, however



o when looked at closely the idea of giving upindividual monetary policy is not a big step for most of the European Monetary Union countries.

o Since the creation of the EMU most member nations have already removed all trade barriers,making it easy to buy and sell goods acrossnational borders. It has also made it very easy tolend and borrow, which means that EMUcountries are already tied together in a semi-unitary monetary policy.

• Main problem - one country can be in recession, andhave no choice but to wait it out.o changing the monetary policy of the whole EMU

for this country would hurt more countries then itwould help.

o The theory is that by creating a single currency

economy throughout Europe, the economies will be tied together, and the business cycles willslowly come together.

o If the business cycles of all the countries were insync, then there would be no fear of one country

being in a recession, while the others wereeconomically stable

• Other ways of dealing with economic problems inindividual countries.o Even though a country gives up its right to

change monetary policy, it still retains the right



to change its fiscal policies before SGP andFiscal Compact.

o EMU countries will still be able to change how

much they tax the people.o If only one EMU country is having economic

problems, then the other countries can raise taxesin order to increase the purchasing power fromthose countries.

Laffer Curve when you increase the tax ( noall tax just the tax know as the top incometax which aimed at the rich) that means themed income are not affected and they willhave more money that will increase

production and thus increase purchasing power). - Firas

This doesn’t really happen, votes etc.

o Extra money can then be used to help bail out thecountry that is having problems.

• Other cost - labor-market reforms had to be made inorder to avoid downward wage spirals.o changes in wage rates were the second of two

ways that individual countries are still able tochange fiscal policy.

o Ordinarily, wages are not prone to movedownward.

o Stipulations were needed for people to make the possibility of wage cuts available to thegovernments.



o In the case of the EMU the stipulation was thatthe EMU governments had few other ways tocontrol the economy. If workers were not willing

to take a wage cut, then many could end up outof the job, because the economy would go bad if the government did not have control of theeconomy.

o No clear outline for the labor-market reforms one of the main ideas was to increase the

ease of labour mobility.

• firms need to make it easier for workersfrom other countries to work outside of their home country.

• The inability of workers to move fromone country to another is mostly basedon language barriers, so that was the

first issue that needed to be looked at.• Measures taken by the EMU to prevent the problems

showed that they were prepared to stick with theeuro.o led other countries from around Europe to apply

for entrance into the EMU.o The idea that more countries were willing to join

the system shows that there was not too muchfear of the downsides.

o If countries from outside the EMU are not shyingaway from joining, that meant that there was



probably not much uncertainty on the insideeither.

• The positives and negatives of the common currency

of the EMU are clear. EMU obviously thought positives out-weighed the negatives.o there was a positive attitude about the euro.o A positive attitude about any currency is one of

the most important factors to its success.o Any time that people have lost confidence in a

currency, either a major recession ensued, thecurrency succumbed to extreme inflation, or insome cases hyperinflation. Confidence in theeuro bodes well for its success in the future.

How has this affected countries?

• The biggest trouble with the Euro is the inability toadjust exchange and interest rates in order to counter

assymetric shocks.

• Germany saw a rise in trade surpluses andcompetitiveness against other euro area members

between 2002-2007 peripheral countries like Spain,Italy and Portugal have fallen behind accumulatinglarge current account deficits as low productivity and

high wages increased.

• With Greece the case was always bad fiscaldiscipline, both before and after the Euro, which ledto the recession they are in now. Their only



sustainable options are imposing austerity measurescoupled with growth and wage adjustments, whiletightening internal fiscal discipline. Greece has made

its bed and is now lying in it, unable to get itself back on top quickly due to € regulations, especially as itshould never have joined the € in the first place.

• € has certainly helped the northern countries, perhapstoo much in hindsight. They ought to look at usingtheir competitiveness (macroeconomic surplus) to

counter a loss of competitiveness is countries likeItaly, Greece and Portugal (i.e financing liquidity tocounter macroeconomic deficits)

• Spain and Ireland especially always had a foothold incompetitiveness

• With Ireland it was hard to converge its economy due

to how quickly it was growing, among other reasons.At one point inflation was as high as 7%, with house

prices rising rapidly.

• The result of handing over control of the moneydecisions to the European Central Bank was thatIreland went through a period of inflation and normal

monetary restraints weren't available to policymakers.

• Difficult to find compromise. This week, Germanyresisted calls to allow the direct recapitalisation in



Spanish banks, in order to save cash-strappedSpanish government from doing it themselves withwhat little they have. Spain is pushing for greater

fiscal integration in Europe.

• Germany contributed to the increase in divergencesin imbalances, hence it may contribute to reducethem through programmes of fiscal expansion and/or high wage growth. Stronger wage growth may have adetrimental effect on Germany by lowering its

competitiveness.• Portugal has a greater debt than Greece, with a fast

shrinking economy. It is also suffering fromdangerously high interest rates on bond yields (above10% for almost a year)

• Countries on the other hand have experienced a boost

in foreign investment thanks to what the Eurozoneoffers, coupled with the numerous advantages of thesingle market

• After adoption of the Euro, some countriesexperienced a temporary loss of growth in order tofulfill the inflation criterion.

• First members of EMU had quite similar economies,later economies suffered because of the one sized fitsall policy. As these were very different, different



rates of growth, policies etc, these reflected also ontheir current balances.

• (OCA) requires that member countries are to behomogenous and integrated as much as possible

because a one-size-fits-all policy within a monetaryunion would not be able to cater the bestcircumstances for all of its members

Optimum Currency Area (Mundell)

In establishing the Single Currency a number of

economic fundamentals were ignored

A group of countries would benefit most by using acommon currency if a number of basic conditions aresatisfied

The extent and volume of trade: “Countries that arehighly integrated with each other, with respect tointernational trade in goods and services, are morelikely to constitute an OCA [...]

since greater trade leads to greater savings in thetransaction costs and risks associated withdifferent currencies.” Frankel and Rose (1998)

Similarity of shocks and cycles: members of the areashould not be subject to asymmetric shocks. Themore highly correlated business cycles are across themember countries, the more optimal is the commoncurrency



Factor (especially labour) mobility: countries withgood opportunities should attract factors of

production, including labour, from those with fewer

employment opportunities.

Fiscal Harmonisation: For a currency area to operateoptimally there should be a harmonised fiscal policy

a central fiscal authority should also be able toredistribute income across the different member states as required.

EMU

Monetary and Fiscal criteria established for countriesto join the Euro are not the same as the OCA criteriaestablished by Mundell.

Monetary Convergence:

Inflation stability

Long-term Interest Rate stability

Exchange Rate: must have remained within thenormal bands of the existing ERM II system of exchange rates, "without severe tensions" for a

continuous period of at least two years. Fiscal Convergence Criteria,

the general government deficit: must be below3% of GDP and



public debt: below or trending towards 60% of GDP.

The euro area has performed better since the creationof the single currency than before

While economic growth has been around 2% sincethe creation of the single currency, similar to its prior

level, employment growth has been strong, fiscal performance has improved and real interest andinflation rates have fallen.

The euro very quickly established its role in foreignexchange and international security markets and has

become an important reserve currency.

Is the EU an OCA?

Similarity of Shocks and Cycles

Similarity of Shocks and Cycles Since monetary policy is now a one size fits all

policy, if cycles are not correlated, the policywill be too loose for the booming economies andtoo tight for the poorer ones

Major difference lies between the Northern more

industrial-based countries and Central EasternEuropean Countries and the SouthernMediterranean countries



Smaller core of EU countries comprised of Germany, France, Belgium, Netherlands, andDenmark form a more homogeneous group, and

therefore more qualify as an OCA.

Closer trade links and an increase in the volumeof trade results in more closely correlated

business cycles

Commission claims that business cycles have become more synchronised between

participating countries during the decade preceding the creation of the single currency

Further integration leads to more diversification;hence, closer trade ties could result in countries

becoming more specialised in sectors in whichthey have a comparative advantage.

asymmetric shocks tend to be more common atthe levels of regions within a country than at thelevel of nations within Europe. De Grauwe

Euro moving further away from being an OCA

Factor Mobility

Factor (especially Labour) Mobility

Low Labour Mobility in the EU due to various barriers. Language, qualifications.



Labour mobility is greater in the US than in theEU

o Various economists believe that labour marketsrigidity is one of the main causes of highunemployment in the EU, especially the Euro Area.

Fiscal Harmonisation

o A single monetary policy (or rather an OCA) requiresa single or common fiscal policy, because if one or

several members increase their spending and debtdisproportionably, they produce negative externalitieson the others, who tend to buy their debt withoutexchange-rate risk.

o US federal budget acts as a powerful stabiliser,enabling fiscal transfers to automatically flow from

booming to slumping states

o Ireland suffered mostly from loose bankingregulation, Italy suffered from low economic growthand Greece from fiscal imprudence

Conclusion

Alternative mechanisms of adjustment in the euro

area were deemed to be comparatively weak. Lowlabour mobility within and across borders, weak

responsiveness of prices and wages to the business

cycle, and the limited degree of integration of



financial markets – along with the absence of cross-

border fiscal transfers

Inadequate fiscal redistribution and Member States’limited labour mobility, a major asymmetric shock would collapse the entire euro area

ECB and monetary policy and the challenges

Intro

o Delors Committee Report identified the need to vestthe responsibility for the single monetary policy in anew institutiono centralised and collective decisions would be

taken on the supply of money and credit as well

as other instruments of monetary policy.o EMU introduced during the second stage of the

economic and monetary union, laid the groundsand acted as a precursor for what was to becomethe European Central Bank

o Established on 1 June 1998, the ECB is asupranational institution with its own legal

personality.

• The central bank for EMU’s single currency

• Responsibility for framing and implementing theEU’s economic and monetary policy



o Not easy as ECB had to create a new currencyand policy by bringing together different nationaleconomic and political systems without causing

reasons for panic in financial markets.o Had to prove that the institution was capable of

managing domestic and international aspects of the Euroarea’s monetary affairs successfully

• European System of Central Banks ECB &national central banks (NCB) of 27 EU member states

• Eurosystem ECB & 17 NCBs of member stateswhich adopted the Euro

Institutional design – Governing Council

o Most important decision making bodyo Formulates policy and adopts guidelineo Plays a crucial role in the administration and

functioning of the ECBo Members : Executive Board + 17 NCB governorso Acts by simple majority – members do not represent

member stateso

Meets twice a montho Meetings are followed by a press conference; refuse

to publish minutes



Institutional design – Executive Board

o Implements monetary policy and gives instructions to

national central banks (NCBs)o Sets the agenda for the meeting of the Governing

Councilo The power of the Executive Board within the sphere

of influenceo Appointed members: the President, the Vice-

President and four other memberso Strong sentiment on collective status of the economy

of the EMUo Still influenced by the desires of the larger countries

Institutional design – General Council

o Members: President and Vice-President of ECB +

NCB governors of 27 member stateso Other members may be present but do not have a

right to voteo Regarded as a transitional bodyo Contributes to advisory function of the ECB, collects

statistical informationo No role in the formulation of monetary policy of the

Eurosystemo Has a supervisory and co-ordinating function for

member states adopting the euro



Objectives of ECB

• According to Treaty - high level of employment and

sustainable non-inflationary growth.o Though considered important, such goals are

second in priority, after price developments. In the long-run growth and unemployment

do not depend on monetary policy, but onstructural factors of the economy

price stability is the most importantcontribution that monetary policy can maketo achieve sound macroeconomicmanagement and a high level of employment.

• Maintain price stabilityo using the rate of change of harmonized index of

consumer prices (HICP) below but close to 2%as a benchmark over the medium term. This is a

benchmark, there is no explicit target.o safeguarding the value of the euroo Increased price transparencyo valuable contribution to a favourable macro

economic environment and employment.

Investors given guarantee that there won’t be price hikes in the future.

o price stability helps to maintain social cohesion,stability and prevents arbitrary redistribution of



wealth. Ultimately, it also contributes tofinancial stability.

• Support the general economic policies of the Union -

maintenance of high employment & sustainable non-inflationary growth, provided they do not hamper theattainment of the objective of price stability

German Model

• The German model vs. the Anglo-French model

o German – based on the objective a central bank should pursue, such as price stability – ensuresthat the central bank is politically independentand no political authority or any other institutionmay revoke or even try to influence a decisiontaken by the central bank

o Anglo-French – based on the institutional design

– having other objectives such as employment,stabilization of business cycles, aside from pricestability - much less independence and thecentral bank to a certain extent, remains under the scrutiny of the government

• The ECB was modeled on the German model. Price

stability remains primary objective and is completelyindependent.

• De Grauwe identifies two main reasons why theGerman model prevailedo development of the monetarist paradigm



o influential if not leading role of Germany in the process towards EMU.

• In view of the size of Germany’s economy it was

nearly natural that Germany would take a leadingrole in negotiating and determining the parameters of the EMU. Germany was very fearful that when it

joined the EMU this was going to impact negativelyits stance on inflation. As a result, their participationwas made conditional to the notion that the ECB putsgreater emphasis on price stability more than theBundesbank did. In other words, this meantEuropeanizing the German model of economicstability.

Eurosystem

• ECB + NCBs which have adopted the euro – Carries

the central bank functions for the euro area which jointly contribute to attain the common goals of theEurosystem

• Will continue to co-exist with ESCB until all member states adopt the euro

• Centralised decision-making, decentralised

operations• Basic principle - having a centralized decision-

making system which then operates via decentralizedoperationso Network of communities



each national central bank and the ECB hasa member.

• Eurosystem carries out the central bank functions for

the euro area. ECB and the national central banks jointly contribute to attaining the common goals of the Eurosystem.

• Basic tasks of the Eurosystem:o the definition and implementation of monetary

policy for the euro areao the conduct of foreign exchange operationso the holding and management of the official

foreign reserves of the euro area countrieso the promotion of the smooth operation of

payment systemso contributing to the smooth conduct of the

policies of the authorities responsible for the

prudential supervision of credit institutions.o Monetary policy two pillar strategy of the

Eurosystem Quantitative reference value for growth comprehensive analysis of a wide range of

other economic and financial variableso Basic tasks all point to maintaining price stability.

Generally successful in 2011, governing councildecided to raise interest rates to push inflation

below 2%.o Overall aim - Safeguarding financial stability and

promoting financial integration



o Establishing an integrated system while ensuring a prominent role for NCBs in implementing andformulating monetary policy . NCBs are

subordinated to the ECB to allow the Eurosystemto operate efficiently as a single entity while alsoact as operative arms

o The Eurosystem and its flaws De Grauwe - Eurosystem is not only

concerned with monetary policy, but has awhole spectrum of activities, functions andinterests.

Institutional setup for ensuring financialstability is mostly a national affair, andfollowing the crisis its ability to manage ithas been seriously put to test.

Central Banking and Assymetric Shocks

o effectiveness of the ECB to respond and stabiliseshocks, particularly when it comes to output andemployment, is partially dependent on whether member states form an OCA.

o If participating member states do not form part of anOCA, the ECB has a much more challenging task torectify the effects of asymmetric shocks and realignthe economies.



o when member states face asymmetric shocks it isunlikely that the ECB will intervene in interest ratesto stabilize output and aggregate demand.

o lack of intervention by the ECB either becausethe divergent situations paralyse its functions or else because it places little attention to outputstabilization.

o ECB has failed to raise interest rates immediatelyeven in times of positive economic situations.

o Often left with a choice between easing or tighteningmonetary conditions

o Asymmetric shocks create a problem of when to react – Policy conflicts arise

o When the degree of asymmetries increases, theeffectiveness of stabilization of output andemployment are significantly reduced

o The ECB has a limited role in responding to permanent shockso ECB has shown a greater degree of flexibility in

responding to asymmetric shocks when itintroduced its two pillar monetary strategy.

o Through its policies it may contribute in the longterm to restore equilibrium

o Temporary shocks – combatted by interest rates &output gap

o A positive asymmetric shock (boom in one member)cancels a negative asymmetric shock (recession inanother member) – lack of reaction from central bank



Conclusion

o Successful in the maintenance of price stabilityo The lack of action to respond to asymmetric shocks

o The need to look beyond price stabilityo The crisis has strengthened the ECB and made it

more influential

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