PQ 11 Flashcards
Germany had a credible central bank before the introduction of the euro
(a) What was their macroeconomic incentive to join the currency union? (2 points)
(b) Was this incentive shared by the countries in Southern Europe? (2 points)
a) 1. Main macroeconomic incentive for Germany
to join the Eurozone was that other countries in
the common currency area could no longer competitively devalue.
- Countries in Southern Europe
had often followed this policy before the 1990s,
harming German’s exports.
b) No. These countries gave up the possibility of competitively devaluing their currency and monetary
policy in order to attach themselves to a credible low inflation monetary policy regime, designed
along the lines of the Bundesbank (central bank of
Germany).
Explain the factors that contributed to the difference in inflation rates between Germany and Spain between 1999 and 2008
What effect did this differential have on the external
competitiveness of these two economies? (explain for Spain) (explain for Germany)
Spain
- High inflation that arose in Spain between 1999
and 2008 was the result of a private sector boom - The Spanish housing boom was a particular driver,
fueled by the cheap credit that was available over
the period. - The overheating pushed output above its
potential level, which meant average inflation over the
period was above the ECB’s 2% target. - This pushed up relative unit labour costs, which led to a fall in the external competitiveness of the Spanish economy, relative to the German economy
Germany
- Germany aggregate demand was depressed, inflation was below target and its external competitiveness improved through nominal wage restraint.
- The coordinated wage setting (recall wage
setting in the labour market from your first year economics) that takes place within the German economy played a role in this outcome.
With relevant examples, explain why the following factors made the Eurozone vulnerable to sovereign debt crisis:
(a) Member countries issued debt in a currency they did not control
(b) National governments were responsible for the solvency of their banks.
a)
- The vulnerability to a sovereign debt crisis of a country that borrows in a currency it does not issue is
illustrated by the examples of Spain and UK - Although the underlying determinants of the solvency (the ‘fundamentals’) faced by the British and Spanish governments in 2011 were quite similar, interest
rates on 10-year government bonds diverged sharply,
reflecting differences in the market perception of the
risk of sovereign default.
b)
- In the Eurozone, responsibility for dealing with insolvent banks rested with member country governments
- This meant that governments had to use national borrowing to pay for the recapitalisation of banks headquartered in their country during the global financial crisis.
- The burden on governments increased (just as
it did in the US and the UK, for example). However,
the big difference is that for a Eurozone member, it
could not rely on a lender of last resort to support
its bond sales if required. - There was no central bank
that would in extremis, purchase its bonds. This issue
is interrelated with the previous point (a). Moreover,
banks in some Eurozone countries were very large in
relation to the size of the economy and hence, of its
fiscal capacity. Ireland is a good example.
Why is the UK less at risk of sovereign default? (two factors)
De Grauwe (2011) highlights two important factors that make the UK less vulnerable to being forced into default by financial markets than a Eurozone country (in a similar fiscal situation):
- The UK has a freely floating exchange rate,
which will depreciate if government bonds are sold
off. This should help to raise growth and increase inflation, both of which are positive for debt dynamics. - If the UK cannot roll over its debts at a
reasonable interest rate, then it could force the Bank
of England (in its role as lender of last resort) to buy
government securities
