Week 11 Deck Flashcards
Define the eurozone? (4)
- Group of countries deciding to adopt a common currency, thereby fixing the countries exchanges rates in relation to one another
- Eurozone is referred to as the European Monetary Union (EMU)
- Consists of 19 members
- Monetary policy is an open economy under fixed exchange rate
Explain the theory of an optimum currency area (Mundell, 1961)
Points to the cost and benefits of a country giving up independent monetary policy and an independent exchange rate
Explain the microeconomic benefits of joining CCA (4)
- Higher trade and investment due to elimination of foreign exchange rate risk
- Resource Savings
- Increased competition
- Increased liquidity in financial markets
Explain the Macroeconomic benefits of joining the CCA (3)
- Reduction of exchange rate volatility
- Delegation authority for monetary policy: importation of stable inflation
- Avoidance of competitive devaluation by members of a CCA
Costs of joining a CCA (1)
- Giving up an independent monetary policy and exchange rate regime
Explain the Eurozone’s performance in its first 10 years (monetary, fiscal, individual performance)
- Eurozone’s performance as a whole prior to the GFC was good
- Monetary policy: ECB’s performance was broadly successful (stable inflation just above 2% target)
- Fiscal policy: Compared to monetary policy, fiscal policy was less successful
- Member countries individual performance pre-GFC was heterogenous
- Indicators of imbalances
- The Real exchange rate
- Current account balances
- Public sector debt
- Private sector debt
- Variation in inflation in member countries
The Eurozone policy regime
Explain the Maastricht Treaty 1992:
- Monetary policy - ECB responsible for:
- Responding to Euro-area wide (common) shock
- Delivering low and stable inflation in the Eurozone (Euro area)
The Eurozone policy regime
Explain Fiscal policy - National governments responsible for:
- Fiscal sustainability and stabilising country-specific asymmetric shocks
- The stability growth pact (SGP) - specifies limit on national budget deficits (<3%) and on government debt-to-GDP ration (<60%)
- SGP aims to prevent policies that threaten the ECB’s inflation objectives
The Eurozone policy regime
explain in terms of Supply-side policy
- National labour product markets and supply-side policies determine equilibrium unemployment
- Supply side reforms supported by EU’s ‘Lisbon Strategy’
Interest rate Differentials
Write out the expected rate of return on bonds
SEE NOTES
Write out the UIP condition written in logs in week 10 and include a risk premium
SEE NOTES
Write out the Eurozone equation:
where p is seen as the risk of a government defaulting on its debt
SEE NOTES
Explain how stabilisation works in the Eurozone (4)
Two levels of stabilisation:
- At the Eurozone level (supra-national)
- At the country-specific level (national)
ECB works as a single monetary policy maker in the Eurozone and members states have no control of their own nominal interest or exchange rates
ECB responds to common shocks: shocks that affects all members.
By choosing the real interest rate to achieve its inflation rate
Draw out the ‘country specific shocks - options available’ diagram
SEE NOTES
Why is a country in the Eurozone (CCA) vulnerable to a sovereign debt crisis? (2)
- Member countries issue debt in a currency they do not control
- Member countries do not have their own central banks
Compare and contrast the governance arrangement of nation states or the US and Eurozone pre sovereign debt crisis
DRAW DIAGRAM (SEE NOTES)
What are the symptoms of a sovereign debt crisis? (2)
- An increase in a government’s default risk
- In the Eurozone, this is reflected by a spread between the I on a members country’s government bonds and that of the German government bonds
The sovereign-bank doom loop in the Eurozone - the panic
What are the two types of vulnerabilities to debt crisis in the Eurozone:
- Private sector debt
2. Excess government defecit pre-GFC => sovereign debt crisis
Explain the issue of private sector debt in terms of sovereign bank doom loop?
Banking crisis => fiscal crisis => sovereign debt crisis
- Bailout costs hits sovereigns balance sheet => debt rises - Recession further worsens fiscal position
Evidence is Ireland and Spain when their house bubble burst even though fiscal position was good
Explain the fiscal crisis in terms of sovereign banking doom loop?
Fiscal crisis = exacerbates banking crisis when banks hold lots of their government’s debt
Incentives for banks to buy stressed sovereign debt due to sovereign debt as very low risk
What are the Possible governance solutions to the Eurozone sovereign debt crisis? (draw diagram and name the 3)
- Fiscal Union
- Economic and political Union
- Banking Union
Explain the logic of a banking union as a reform proposal for governance in the Eurozone?
Supporters of a banking union: a banking union’s objective is to avoid banking crises and will provide arrangements for the resolution of failing banks
- To deal with the doom loop problem
- To free member governments to be able to stabilise country specific shocks
- Single Resolution Mechanism - member countries are jointly responsible for bank solvency
- Ensures national governments remain intact
Explain the logic of a fiscal union as a reform proposal for governance in the Eurozone?
Supporters of a fiscal union: objective is to have a central government to allow for automatic stabilisation of country specific shocks through automatic stabilisers
- To provide adequate stabilisation at the supra-national level
- To deal with the threat to the sovereign banking crises
Possible governance solutions to the Eurozone sovereign debt crisis
Explain the policy steps to monetary policy
- ECB - massive injection of liquidity to support the banks
- Draghi statement -> panic receded and the risk premia fell this solvency of governments improved
- But weak growth and fear of deflation
- QE (2015 to 2020)
- The spectre of deflation again in 2020!
- A Eurozone banking union requires banking reform.
- Otherwise banking union could mutualise the implicit government guarantee to banks
- Banking reform is needed whether or not there is banking
- Break the doom loop by incentivising banks to diversify
- Create a European deposit insurance system (supra nations)
- Break the doom loop by incentivising banks to diversify
