International Economics - Assignment Example

International Economics Assessment – 1 Name (s) 1._______________________________________________________________________ 2.________________________________________________________________________ 3.________________________________________________________________________ Student ID 1._____________________________ 2._____________________________ 3._____________________________ Assessment 1: Note: This is a group assessment. In any group maximum of 3 members are allowed. In mentioned cases provide a neat diagram to explain your answer. Make sure to label axes properly. Else points will be deducted. The maximum possible points are 40. Maximum points: 40 points 1. The following excerpt is from the case study “The Euro in crisis: Decision Time at the European Central Bank”. (distributed in the class) “……a bailout for Greece would send a signal to other indebted member states that the ECB would step in if private lenders become nervous.” Answer the following questions with appropriate diagram and using AD-AS model, Money market, aggregate expenditure model, and forex market (as required). For part a, b and c appropriate diagrams are MUST. Else points will be deducted. a. When ECB went out for bail out then what was expected to happen to the interest rate in Greece? (10 points) When ECB went out for bailout then in 2010, two different rescue programs had been started by ECB which are called as the European Financial Stability Facility and the European Financial Stabilization Mechanism. As a result of the bailout of ECB, Greece has been receiving the financial assistance from ECB since the May of 2010. In the August of the year 2015, a third program had also been launched under the European Financial Stabilization Mechanism framework[Eur16]. However, when ECB was going for the bailout then the interest rates in Greece were expected to decline and reach to low levels. This is because, Pre-Euro, the devaluation of the currency had helped the country to finance the Greek government spending. Thereafter, later on this tool disappeared. But still Greece was able to borrow because of the lower interest rates especially for the euro bonds and the GDP growth of the country had also been strong[Eur16]. Athens especially was required to dramatically reduce the level of the deficit by cutting the minimum wage and squeezing the pensions. The overall impact of the bailouts was a huge decline in the interest rates and the passing of the debt from the private sector to the public sector. This is depicted in the graph shown in exhibit 1 in appendix. b. Comment on the expected outcome of this policy on behalf of ECB. Provide diagram and detailed explanation on output and prices. (10 points) During the outbreak of the financial crisis, there are a number of the euro area governments have provided the financial assistance to a number of the countries around the world in order to avoid a credit crunch. All of these measures, however, had caused an increase in the euro area general government debt and this had risen by around 28% between 2008 and 2014[Ned15]. As a result of this rapid increase in the debt levels, the southern euro zone member states had become unable to repay their total government debt which was euro denominated and they also failed to finance the bail out of the troubled financial sectors without the required assistance from the third parties. This had resulted in an overall European debt crisis. Looking at this severe sovereign default, the international and the European institutions, the general public and the financial community had started to evaluate and re-assess the creditworthiness and the economic situation of the euro zone states[Ned15]. This had a huge impact on the world economy in terms of the output and the prices. This is because in order to fight back with the crisis some of the governments had emphasized on lowering the expenditures and raising taxes and this had contributed towards significant debate among the economists and also social unrest. According to the IMF Economic Outlook, the growth of the euro zone would be 1.2% in 2015 and 1.4% in 2016[Ned15]. Even the growth forecasts for Spain and Greece are much higher than the average of the Euro zone. The huge increase in the consumer price index which shows the price level change in the market basket of the consumer goods and services in exhibit 2 shows the distortion of the prices and the decline in the output could be seen in exhibit 3 in the appendix. c. If government of Greece also increases (assume) the expenditure (expansionary fiscal policy) then what do you think can potentially happen to prices? Provide the relevant diagram and explain your answer.(10 points) The expansionary fiscal policy through an increase in the expenditure of the country would require the support of the government in order to increase the total aggregate demand. The government of Greece will have to lower the rate of the tax and a higher spending by the government. The lower taxes, increase in the expenditure will cause an increase in the disposable income of the consumers and it will lead towards the higher levels of the consumer spending[Tej09]. The aggregate demand in the economy would increase and the economic growth would boost but the main issue here will be that the prices would increase due to a significant increase in the aggregate demand. This increase in the price is shown from P1 to P2 in exhibit 4 chart in the appendix. The impact of the expansionary fiscal policy in terms of increase in the expenditures would however, depend on a number of different factors[Tej09]. These factors are discussed briefly below: As the expansionary government fiscal policy would involve more borrowing by the government and higher expending leading to increased expenditures, therefore, it can cause crowding. This means that despite the increase in the expenditures, they borrow from the private sector and the private sector has then less to invest and spend and overall the aggregate demand does not increase. The timing of the increase in the expenditures will also impact on the increase in the aggregate output. For instance, if the expansionary fiscal policy is adopted at a time when the economy of the country is operating at a full capacity then the increased borrowing by the government can cause higher inflation and crowding out. Finally, there is also certain supply side effects such as the decrease in the income tax might increase the incentive to work. d. Overall do you think that bail out of Greece is healthy policy from the perspective of ECB? Answer this one in context of the Case study. ( 5 points) Greece had approached the International Monetary Fund for the Bailout and on 2nd of May, the EU had agreed on a 110 billion euro support package but the markets were not at all allayed. However, the risks associated with this move were also many from the perspective of ECB. First of all, on a European level a bailout for Greece would send a signal to the other indebted member states that the ECB might set up in if the private lenders become nervous. The confidence in the support of the ECB could also lead towards reckless spending. This was the moral hazard problem and it also applied to the EU policymakers. Any single move by the ECB for diffusing the Greek debt crisis could take the pressure off of the national finance ministers for negotiating a political response which would be robust enough for managing the fiscal over runs over the longer term in all of the member states. The intervening also posed risks for ECB itself. Price stability is considered as the core function of any of the modern central bank. However the overt move by the company for supporting the debt crisis for a specific member state had opened the ECB to the political meddling. If at this point a line is not drawn by ECB then this would become the first responder for each of the future fiscal crisis. Finally, the 60 billion euro outright purchase of the debt for Greece could also be absorbed into the balance sheet of the ECB and thus purchasing the debt for a large country like Spain could have severe inflationary consequences. e. Explain why a group of economist thinks that a common currency like Euro for the region is not a good idea. Restrict your answer to the concepts discussed in the class and the case study. Page limit is one page. (5 points) The group of the economists believed that the idea of a single currency like Euro for the region is not a good idea because without a greater economic alignment of all the member states, a common currency could precipitate a civil war within Europe. Another set of the observers had stated that there were also risks associated with the centralization of the monetary policy as the fiscal authority remained under the control of the member states. As the benefits of the fiscal stimulus were local and all the costs of the monetary tightening were felt across the entire Europe, therefore, the economists have warned that there was a risk that the individual member states could over stimulate their fiscal economies through fiscal imprudence. As a result of this, ECB would then impose higher rates of interest than otherwise would have been required, in order to meet the required inflationary targets. Overall, this would result in a lower economic growth across the entire euro zone. This is also evident from the devaluation of the currency. For instance, in the early years of the euro currency existence, all the above misgivings regarding the currency of euro seemed to be unfounded. The currency had been introduced at the rate of $ 1.17 against the US dollar in the year 1999 but only as an accounting currency. In just about 1 year the value of the currency fell to 83 cents because of the launch of the paper currency. This shows that the views of the economists were right. Appendix Exhibit 1 Source: ECB Exhibit 2 Source: Fred Exhibit 3 Source: Bloomberg Exhibit 4 Source: Economicshelp.org References Eur16: , (Commission, 2016), Ned15: , (Nedergaard, 2015), Tej09: , (Pettinger, 2009), Read More