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EC204 Macro Notes > The Open Economy: The Eurozone > Flashcards

The Open Economy: The Eurozone Flashcards

1
Q

What are the microeconomic benefits of being in a currency union?

A

Higher trade and investment, reduced spending on currency transactions, increased competition

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2
Q

What are the macroeconomic benefits of being in a currency union?

A

Reduced exchange rate volatility, improved inflation targeting, no competitive currency devaluation amongst members

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3
Q

What are the macroeconomic costs of being in a currency union?

A

No longer able to use monetary policy, can’t control exchange rate to correct for localised shocks,

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4
Q

What was inflation and output gap performance in the Eurozone?

A

There was low average inflation

German deviation from inflation target was very low -> was because people believed they controlled the ECB

Greece, Spain, Ireland and Portugal had above average inflation and output gaps

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5
Q

Is having large positive inflation necessarily a bad thing? When is it not a bad thing?

A

It is not necessarily a bad thing if the inflation matches the increases in nominal wages

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6
Q

What was RER and current account performance in the Eurozone?

A

Spain and Italy both had an appreciated RER which saw their competitiveness fall -> current account deteriorated

Germany saw a depreciated RER which saw their competitiveness rise -> improved current account

France’s RER remained fairly constant but their current account worsened

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7
Q

Why may your current account still worsen even if RER is fairly constant?

A

If you are producing the wrong goods or the goods that you are producing are poorly made

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8
Q

What was the debt performance in the Eurozone?

A

Public and private debt levels evolved differently as varying levels of fiscal policy were used

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9
Q

What impact did the 2008 financial crisis have on debt levels in the Eurozone?

A

All countries, even the more stable ones, saw their debt levels rise

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10
Q

What policy decisions were made in the Maastricht Treaty in 1992?

A

ECB was responsible for monetary policy -> aiming to attain low and stable inflation and will respond to common shocks

National governments are responsible for fiscal sustainability and stabilisation of country-specific shocks. Stability and Growth Pact (SGP) was part of that

National labour and product markets and any domestic supply side policies will determine equil. unemployment

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11
Q

Who was the single monetary policymaker in the Eurozone and what was their inflation target?

A

The ECB was the only one in control of monetary policy and their aimed at inflation close to but below 2%

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12
Q

How did some countries criticise the ECB inflation target?

A

They said that it was too low and was increasing the potential for deflation within the Eurozone

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13
Q

What 2 pillars are used by the ECB when setting the interest rate?

A

Economic and monetary pillar

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14
Q

What did the economic pillar focus on in ECB monetary policy decisions?

A

Used forecasts of output gaps and inflation deviations to inform decisions about what interest rate to set

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15
Q

What did the monetary pillar focus on in ECB monetary policy decisions?

A

Used and focused on broad money growth rates

Broad money = the amount of money flowing through an economy

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16
Q

Why did the monetary policy have to be forecasted?

A

Because there is a lag when that policy is introduced

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17
Q

Was the ECB’s monetary policy successful?

A

Broadly -> inflation was stable just above 2%

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18
Q

What limitations did the SGP put on Eurozone members fiscal policy regimes?

A

National debt to GDP ratio could not exceed 60%

National budget deficits could not be larger than 3%

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19
Q

Why were these SGP limitations put on debt levels?

A

Sovereign debt risks will upset financial markets which can have spillover effects on other countries that use that currency

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20
Q

What incentives would a country have to run large levels of debt?

A

If they are a small country it will boost AD if they increase their spending which will boost output and employment

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21
Q

Why would it be an issue if all members of the Eurozone had large levels of debt and spending?

A

It would see inflation increase significantly, meaning that the ECB would have to increase r to reduce inflation

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22
Q

How successful were the Eurozone fiscal policy limitations?

A

There were not very successful with several countries breaching the limitations

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23
Q

Why did several countries breach the fiscal policy limitations?

A

Because they used it to correct country-specific shocks and the limitations did not allow for much flexibility to allow them to react well to those shocks

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24
Q

What exchange rate regime does the Euro Area use compared to the rest of the world?

A

A freely floating regime

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25
Q

How does the Euro Area’s exchange rate regime allow them to stabilise shocks?

A

It allows the ECB to use the interest rate to respond to common shocks that occur within the Eurozone

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26
Q

How does the RER channel stabilise an economy after a shock?

A

Due to prices increasing as result of the shock -> Q decreases -> means that competitiveness falls -> net exports fall -> output falls -> inflation drops and economy moves back to MRE

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27
Q

How does the RIR channel destabilise an economy after a shock?

A

Inflation shock -> increased inflation expectations -> real interest rate falls (s.t. fisher equation) -> output increases -> inflation further increases -> economy moves further from MRE

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28
Q

Do the RIR and RER channels need policy action?

A

No, they both happen automatically

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29
Q

What does Walters’ critique state?

A

That instability will arise if Taylor Principle does not apply to country-specific shocks in a CCA

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30
Q

What is the Taylor Principle?

A

That there needs to be a -ve output gap to dampen inflation

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31
Q

What happens if the RIR channel dominates the RER channel and how will the government have to respond?

A

If the RIR dominates then this will destabilise the CCA, so the country will need to use contractionary fiscal policy to correct it

32
Q

Why will domestic competitiveness increase if domestic inflation is below the CCA level?

A

Given that e is constant as the CCA exchange rates are fixed, then the ratio of home prices to the other CCA prices will improve

33
Q

What inflation rate do we assume that CCA countries are operating on?

A

The target inflation set by the ECB

34
Q

What happens when we log differentiate the RER equation and what does that imply about competitiveness?

A

Equation: (change in q) = (change in p*) - (change in p)

So if P drops, then q will increase and this will cause competitiveness to increase

35
Q

How does the differentiated RER equation prove the RER stabilisation channel when there is an inflation shock?

A

The inflation shock will cause P>P* meaning that Q will decrease -> this reduces competitiveness -> reduces net exports -> decreases y -> reduces inflation

36
Q

For a diagram about the RER stabilisation channel:

A

Check notes

37
Q

What inflation expectations are assumed to exist in the RER channel?

A

Anchored

38
Q

How does there being anchored expectations affect the PC diagram?

A

It means that PC will not shift, inflation expectations are unchanged so the PC will not shift

39
Q

What will be the case if there are adaptive expectations?

A

Then expectations might be that inflation will still remain above target after period 1

40
Q

How does expecting above target inflation impact the PC curve in a RER channel diagram?

A

It will mean that the PC will shift up to above its original level and inflation will be greater than target -> this will cause the IS to shift further to the left reducing output further

41
Q

What would happen if the PC shift is larger such that expected inflation < target inflation?

A

Then the RER will depreciate and the IS will shift right as output will increase

42
Q

What do we assume inflation expectations are like in the RIR channel?

A

Adaptive

43
Q

What happens to the PC after an inflation shock in the RIR channel and how does that impact inflation expectations?

A

The PC will shift up as the inflation shock takes place which will mean that inflation expectations will also increase

44
Q

What do the higher inflation expectations in the RIR channel have on r and does that further impact inflation and output?

A

The higher inflation expectations will cause r to decrease (fisher equation) which will mean that output will increase further and as such inflation will also continue to rise

45
Q

What role does FP have for CCA member countries?

A

It is used to stabilise after idiosyncratic shocks and reduce the impact of the RIR channel

46
Q

For diagram comparison of FP and MP response after an inflation shock

A

Check notes

47
Q

How will the government react using FP to an inflation shock?

A

They will reduce G so that output and inflation are reduced

48
Q

What impact does a +ve inflation shock have on Q?

A

It will cause Q to decrease

49
Q

How will the government adjust FP going forward after an inflation shock?

A

After having reduced G at the start to reduce y and inflation, they will start to gradually increase G again so that output increases again as inflation decreases

50
Q

What will be the net state of the RER after an inflation shock when using FP and how does the government work to correct that?

A

The net RER will be appreciated so that government will have to increase G past the level it was at during the initial equilibrium to overcome the loss of income from the appreciated income -> creates a fiscal imbalance

51
Q

What is wage restraint?

A

When wage doesn’t respond to shocks

52
Q

How does wage restraint help stabilisation after a shock?

A

It will help to anchor the PC during the shock as nominal wages have not changed

53
Q

What is the downside of wage restraint for workers?

A

It means that they will see a short term reduction in real wage as prices increase during the shock

54
Q

How does wage restraint help the RER channel to stabilise?

A

Due to wage restraint it will mean that inflation in the economy will not rise and as such will be below target -> this increases Q -> demand will stabilise

55
Q

What will happen after a shock when wage restraint is not exercised?

A

It means that wage will sluggishly adjust to the shock causing the PC to shift out -> RIR channel takes effect -> FP needed to stabilise

56
Q

Where is an example of where wage restraint was shown and how was it shown?

A

It was exercised in Germany where wages change in accordance with the competitiveness requirements of the export sector

57
Q

How would wage restraint vs no wage restraint be shown in a diagram?

A

Wage restraint = RER channel diagram

No Wage restraint = RIR channel diagram

58
Q

What is sovereign debt?

A

Debt issued by the government to fund its spending

59
Q

What is sovereign default?

A

When a country is not able to pay back its loans and debts so they have to be cancelled

60
Q

How does the existence of different default risks affect the larger CCA?

A

Given that different countries have different default risks, it means that the interest rates will differ across the CCA

61
Q

For UIP adjusted equation

A

Check notes

62
Q

What is exchange rate risk?

A

The risk that the exchange rate will change and alter the value of your interest rate

63
Q

How does the adjusted UIP equation show that interest rates can differ?

A

Because exchange rate risk (which will be same for all CCA members) and default risk have been added (default risk will be the key differing factor)

64
Q

How does some countries having a higher default risk potentially have spillover effects on other CCA members?

A

Because the debt costs of all countries may increase as overall confidence in the CCA may be reduced

65
Q

How did the financial crisis affect interest rate levels?

A

It caused interest rates across the board to increase significantly as debt levels rose a lot

66
Q

How does all countries in the Eurozone using the euro reduce interest rate differentials?

A

Because they will all have the same exchange rate risk -> this risk will not differ across the countries

67
Q

What was the ECB’s initial standing regarding debts after the financial crisis?

A

It stated that it would not be bailing out governments

68
Q

How did the ECB change their debt response and why?

A

They started bailing out governments in Q1 2012 because they wanted to do anything to protect the euro

69
Q

How did the ECB buy up debts after the financial crisis?

A

They invested in government bonds

70
Q

How did the ECB buying more bonds help the countries?

A

It increased the prices of the bonds which reduced the interest rates as default risks fell

71
Q

How did the ECB help reduce default risk?

A

They increased confidence in Eurozone countries as others knew that they would bail out Eurozone members if they had excessive debts

72
Q

What were the core elements of the Eurozone pre-crisis governance arrangements regarding debts?

A

1) there was a no bailout clause between governments
2) the ECB would provide no monetary financing to member governments (cannot provide credit to govnts)
3) Fiscal rules were in place that supported the first 2 arrangements

73
Q

For visuals about governance arrangements comparisons between nation states and the Eurozone

A

Check notes

74
Q

How did the ECB change their governance arrangements after the financial crisis?

A

1) no bailout clause between governments was broken
2) ECB changed its role to LOLR to member governments
3) banking union was established

75
Q

What was the first pillar of the ECB banking union and what did it mean?

A

Single Supervision Mechanism -> the ECB would monitor and supervise big banks within the Eurozone if they agreed to it so that governments could supervise the smaller domestic banks

76
Q

What was the second pillar of the ECB banking union and what did it mean?

A

Single Resolution Mechanism -> any bank that is failing under the SSM will be restructured and resolved at the lowest cost possible to taxpayers and the larger economy

77
Q

For possible future interventions

A

Check notes

EC204 Macro Notes (8 decks)

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