the costs of a common currency# Flashcards
what are the costs of monetary union derived from?
it is derived from the fact that when a country relinquished its national currency, it also relinquishes its independent monetary policy to stabilise the economy
who sets the interest rate for the euro zone?
the european central bank
when is the loss in interest rate and exchange rate instruments most costly to countries in a common currency?
it is most costly when the member countries experience asymetric shocks and need to stablisise their buissness cycle
what are the two mechanisms whihc can automatically bring back equillibirum in the two economies in a single currency area who experience a shock
the two mechanisms are wage flexibility and labour mobility
how does wage flexibility automatically bring back equillibrium between two member states in a single currency experiencing a shock
french workers will agree to accept lower wages to avoid bieng laid off work. aggregate supply in france will then shift downward
wages will go up in germany due to upward pressures in the labour market and so aggregate supply in germany shifts upwards
how does labour flexibility automatically bring back equillibrium between two member states in a single currency experiencing a shock
excess french workers will move to germany. wage does not need to fall in france or rise in germany
the unemployment problem is removed in france and rising inflationary wage pressure is removed in germany
just the AS curve shifst to keep price level constant
what is the issue of labour mobility in the eurozone?
the labour mobility is very limited in europe and especially for low skilled workers
if wages and prices are not flexbile, and labour is not mobile then the monetary union will be costly
thus when asymmetric shocks occur and when there are a lot of rigidities, france will experience sustained unemployment and the adjustment process leads to higher inflation in germany
monetary union may potentially be more costly than not being in a monetary union
how does the eurozones debt to GPD ration compare to the UK and US after 2007?
the increase in the debt to GDP rations since 2007 are significantly faster in the US and the UK than the eurozone
how has the eurozone fundamentally changed the capacity for governments to finance their budget deficits?
when countries join a monetary union they lose their monetary independence. euro member countries issue debt in euros. national govts have no control of the euro as the currency is controlled by the ECB
what is a simple representation of the governments budget constraint
[1+R(t-1)]B(t-1) +G(t) = B(t) + T(t) where R(t-1) is the nominal interest rate issued in time t-1 and repaid in period t, B(t) is the stock of nominal debt at the end of time t, G(t)-T(t) is the primary surplus/deficit
what would occur if the investors fear default in the case of the UK government?
they sell the govt bonds which increase the yield. the pounds are sold on the forex market and sterling drops in value so the UK money stock remains unchanged. part of the pounds will be reinvested in UK govt securities. if not bank of england can buy UK govt bonds. investors cannot trigger liquidity crisis for UK govt
what would occur if the investors fear default of spanish govt?
they sell spanish govt bonds which increase the yield. money received of these sales are invested in other euro area assets. spanish money stock declines. ECB provides liquidity to the euro area as whole and ECB is not controlled by spanish govt. liquidity crisis possible when spanish govt cannot fund bond issues at reasonable interest rate. investors can force to spanish govt to default.
what is the self fufilling prophecy about investors distruct in a country?
when investors distrust a particular member states govt they will sell the bonds thereby raising the interest rate and potentially trigerring a liquidity crisis. with a higher interest rate, the govt debt burden increases. this forces the govt to reduce spending and increase taxation. such bugetary authorority is politically costly and may lead the government to stop servicing the debt and to declare a default. the standalone countries issue their debt in their own countries and thus they can always create the liquidity to pay out the bondholders. however creating additional liquidity to finance debt by money creation leads to higher inflation
what are the important interactions between asymmetric shocks and debt dynamics?
negative shock in france increases the budget defecity in france due to automatic stabilisers. if market lose trust in french government then the effect of the assymetric shock is amplified. investors sell french government bonds and this leads to an increase in the interest rate and a liquidity crisis in france ,with a higher interest rate in france, the countries aggregate demand curve shifts further to the left. when investors sell french bonds, they are likely to buy german government bonds that they trust. the german government bond yield declines. aggregate demand curve shifts upwards in germany intensifying the boom in germany
what are the other sources of asymmetry?
– Symmetric shocks (e.g. oil shocks) are transmitted differently and lead to wage and price divergence– Centralized versus non-centralized wage bargaining– In countries with centralized wage bargaining, labor unions take into account the inflationary effect of wage increases. Therefore, wage increase is moderate– In countries with decentralized wage bargaining, labor union bargaining leads to higher wage inflation.– The same shock shifts supply curve upwards more in one country than others.
