The Eurozone Flashcards

Question

Current problems affecting the future of the eurozone

Answer 1

» Cyclical recovery - then stalled revealing underlying problems remain. » Heterogeneity across countries. Germany has fiscal space but is at high employment. The countries that need to generate domestic demand such as Italy don’t have fiscal space (pro-cyclical rules). » Over reliance on blunt and weak common instrument of monetary policy.

Answer 2

* » Create Eurozone deposit insurance system BUT only after successful banking reform. * » Create euro area fiscal capacity BUT only after high government debt levels brought down. * » Give European Stability Mechanism (rescue fund established in 2012) more resources BUT only after the non-performing loans problems are resolved. * Meanwhile, a crisis is looming unless underlying issues are resolved. * Banking union still unfinished business and progress is slow.

Answer 3

The Eurozone is a common currency area but individual member countries are heterogeneous thus it is not yet an optimum currency area. The Eurozone’s performance in its first 10 years was broadly successful but there were major imbalances in member countries individually. Private sector indebtedness: » the banking crisis which contributed to the fiscal crisis. » consequently the Eurozone sovereign debt crisis. Policy steps have been made since the Eurozone crisis but are insufficient to avoid a similar crisis.

Answer 4

1. Banking union. 2. Fiscal union. Banking union aim is to prevent banking crises but allow fiscal policy to remain national, a major source of fiscal conflict among members of Eurozone. Fiscal union aim is to centralize fiscal policy to enable stabilization of country-specific shocks via automatic stabilizers and lend credibility to banking union. Among Eurozone members, there is political opposition to full economic and political union – as in the US.

Answer 5

Countries in the Eurozone do not have independent monetary policy and it is obvious to think of fiscal policy being used as an alternative stabilization policy instrument. But in a common currency area, the use of fiscal policy by one member can have spillover effects for the currency area as a whole. This possibility led the Eurozone to adopt a fiscal policy framework for its members called the Stability and Growth Pact.

Answer 6

The Eurozone crisis brought to the fore the need to model the vulnerability of a member of a common currency area to a sovereign debt crisis, where financial markets attach very different risk premia to the government bonds issued by different member country governments. This requires an explanation of the relationship between banks, government and the central bank The role of Eurozone membership is highlighted by the contrasting experiences of Spain and the UK. Although the underlying determinants ofthe 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. This divergence demonstrated the vulnerability to a sovereign debt crisis of a country that borrows in a currency it does not issue. As a member of the Eurozone, the Spanish government borrows in euros, but it is the Eurozone central bank, the ECB, which issues euros.

Answer 7

The political impetus for creating a common currency area in Europe was increased as a consequence of German reunification in 1990. In economic terms, German industry favoured monetary union as a way of preventing its competitors in France, Italy and Spain from using exchange rate depreciation as a tool to regain competitiveness, as had happened under previous exchange rate arrangements. The private sector and policy makers in France, Italy and Spain saw Economic and Monetary Union as a means of acquiring a credible low inflation policy regime through a German-style inflation targeting central bank at the level of the common currency area. The themes of competitiveness and the behaviour of wage and price setters under the new rules of the game of a currency union play a big role in this chapter. The theory of an optimal currency area points to the costs and benefits of a country giving up independent monetary policy (and an independent exchange rate).

Answer 8

The theory of an optimal currency area highlights the main macroeconomic cost incurred byjoining a common currency area: the policy maker is no longer able to use monetary policy (and the associated change in the nominal exchange rate) to adjust to country-specific shocks. This cost falls with the degree of integration between a country and the rest of the CCA. The more closely the business cycle of a member is correlated with that of other members, the better will be the stabilization performed by the CCA central bank. 1. The degree of wage and price flexibility: domestic wage flexibility can substitute for a flexible nominal exchange rate since changes in prices influence the real exchange rate. For example, a period of wage and price growth below that of the other CCA members will make a country more competitive and boost net exports. 2. The mobility of labour: in principle, closer economic integration makes labour more mobile and this provides a shock absorber that can help substitute for the loss of the ex- change rate instrument. This channel works particularly well in the US, where the movement of workers across state borders is fluid. National differences in language, training and ac- creditation, and in the flexibility of housing markets are among the reasons for the limited mobility of labour across national borders in the Eurozone 3. The size of fiscal transfers: the bigger the central (i.e. Eurozone level) tax and transfer system, the more automatic stabilization there is for country-specific shocks). This channel does not operate well in the Eurozone, as the EU budget is tiny. In comparison, in the United States, the federal tax and transfer system is much more substantial.

Answer 9

1. The reduction in exchange rate volatility and the removal of exchange rate overshooting from economic adjustment. 2. By giving up control of monetary policy to the ECB, countries which could not successfully manage inflation through their own central bank could 'tie their hands' and establish a low inflation monetary policy regime. This was a key reason for the southern European economies to join the euro. 3. The other countries in the CCA can no longer competitively devalue. Ruling this out was a major selling point of EMU membership to the German public, who already had a credible low inflation monetary policy regime before joining the euro (i.e. the Bundesbank).

Answer 10

In its first decade and before the global financial crisis, the performance of the Euro area as a whole was close to target for inflation Most countries displaying a small positive output gap. This suggests that the ECB was successful in managing shocks common to the Eurozone. However, Fig. 12.1 shows very clearly how much variation there was in the performance of Eurozone member countries: at the top are the four Eurozone countries involved in the Eurozone crisis from 2010, Greece, Spain, Ireland and Portugal. These countries all had average inflation rates well above the ECB's inflation target of 2% and positive output gaps during the first decade of the euro. In the opposite corner with inflation below the target and with a negative output gap is Germany. Individual country performance was very diverse. how even when the nominal exchange rate is fixed, real exchange rates can move very differently: Spain's competitiveness relative to the Eurozone average fell by 26% over the first decade of the Eurozone, whereas Germany's improved by 17.5%. These divergences in external competitiveness were reflected in the build-up of current account imbalances, as shown in Fig. 12.2. We can see that Spain and Italy built up large current account deficits in the first ten years of the single currency, whilst Germany ran a large surplus.

Answer 11

The Maastricht policy assignment 1. The ECB is responsible for using monetary policy to respond to Eurozone-wide shocks and for delivering low and stable inflation in the euro area. 2. National governments are responsible for fiscal sustainability and subject to that, for providing stabilization for country-specific shocks and for the asymmetric effects of common shocks (i.e. for dealing with the fact that common shocks may have different effects in different member countries). 3. The aim of the European Union's Stability and Growth Pact was to prevent governments from pursuing policies that might threaten the ECB's inflation objective. 4. National labour and product markets, and national supply-side policies would deter- mine equilibrium unemployment. However, supply-side reforms would be supported by the European Union's 'Lisbon strategy'. The Lisbon strategy was a European Union pro- gramme for the 10 years from 2000 aimed at making the EU 'the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion'

Answer 12

The ECB is politically independent of governments-its constitution reflects the legacy of the German central bank, the Bundesbank, and as a result it is more independent than either the Federal Reserve in the US or the Bank of England. it sets its own monetary policy in terms of its target (price stability, defined as an inflation rate of close to but below 2%). it uses its policy instrument, the interest rate, to achieve this target, considering both economic and monetary 'pillars' The economic pillar uses forecasts of the output gap and the deviation of inflation from target to inform the interest rate decision. In contrast to most other independent central banks (e.g. the Bank of England), the ECB has an asymmetric inflation target. The target impi ies that the ECB wou Id be happier with inflation 1% below target than 1% above target. The target has been criticized on the grounds that it leaves the Eurozone more vulnerable to deflation than would be the case with a symmetric target. The interest rate decision also reflects the second pillar of the ECB's monetary policy strategy. The second, or monetary pillar reflects the influence of the legacy of the German central bank, the Bundesbank. Unlike many central banks, the Bundesbank had considerable success in targeting the growth of the money supply as part of its price stability mandate. This contrasts with the failure of monetary targeting elsewhere n addition to using information from the economic pillar to set the interest rate, the ECB also uses the monetary pillar. For this purpose, it uses a reference growth rate of a broad monetary aggregate. The ECB's inflation target is a rate below but close to 2%

Answer 13

The Stability and Growth Pact (SGP} specified that national budget deficits be kept below 3% and that the ratio of government debt to GDP be kept below 60%. The choice of these particular numbers can be rationalized by noting that a debt ratio of 60% was the average of the EU members in the years preceding the formation of the Eurozone; and with a debt ratio of 60%, the debt to GDP ratio will remain constant if the nominal growth rate is 5% and the budget deficit is 3% of GDP.1 concern about the deficits and debt levels in member countries arises because of fears of spillovers from national policy decisions to the Eurozone.