IMPORTANT: THIS ESSAY IS SPLIT INTO 2 QUESTIONS, BOTH 1500 WORDS.
Q1. Considering the current budget deficit/debt problems faced by some members of the Eurozone, critically evaluate the argument that countries in a monetary union should coordinate their fiscal policies (1500 Words)
Core Information: Carl & Soskice (2015) Textbook – Macroeconomics: Institutions, Instability, and the Financial System, Relevant Chapter: 12- The Eurozone
The textbook is available online through sources such as Academia, just make an account and the whole textbook and referenced chapters are on there.
Below are some discussions from the seminar we did relating to the topic, should give an overview of the taught material and provide the basis for certain arguments, as well as providing the foundation for more academic related arguments through the use of journal articles and reports. (Discussion below is more or less based off chapter 12 in the above textbook)
- What are the microeconomic benefits of a currency union?
There are 4 main microeconomic benefits:
- The elimination of exchange rate risk should lead to higher levels of trade and investment.
- Real resources are saved with the removal of transactions costs that occur during currency conversion.
- Increased competition in the product and labour markets, due to greater ease of price and wage comparisons.
- Increased liquidity in financial markets. This is of particular benefit for small member countries.
- Germany had a credible central bank before the introduction of the euro. What was their macroeconomic incentive to join the currency union? Was this incentive shared by the countries in Southern Europe?
The main macroeconomic incentive for Germany to join the Eurozone was that other countries in the CCA could no longer competitively devalue. Countries in Southern Europe had often followed this policy before the 1990s, harming German’s exports. These countries gave up this possibility in order to attach themselves to a credible low inflation monetary policy regime, designed along the lines of the Bundesbank.
- What are the two pillars of the ECB’s monetary policy? Discuss the pros and cons of the ECB’s strategy.
The two pillars of the ECB’s monetary policy are economic and monetary. The economic pillar makes use of the analysis of 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 implies that the ECB would 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 second, or monetary, pillar uses a reference growth rate of a broad monetary aggregate. Economists have criticized this second pillar, on the basis that other central banks in the past failed to successfully target money growth. In contrast, monetary economist (and former member of the Bank of England’s Monetary Policy Committee) Charles Goodhart (2006) argued that if inflation expectations come to be more closely anchored to the target, inflation may no longer be a good signal of future inflationary pressure. Under these circumstances, relying only on the economic pillar could be misleading and the growth rate of a money aggregate may be a more relevant indicator of future inflation.
- What is the Walters’ critique and why was it used as an argument for the UK not joining the single currency?
According to British Economist Alan Walters, if a principle similar to the Taylor rule is not applied to a member of a CCA, so that the required negative output gap is created to dampen inflation (through the combination of tighter fiscal policy and the operation of the real exchange rate channel), then instability can arise. Walters used this argument to reinforce his reasoning against UK membership of the euro.
- Use the 3-equation model to show how fiscal policy can be used to stabilise the economy after a positive demand shock in a country that is a member of a common currency area (CCA). What effect does this have on the budget balance?
The demand shock increases output above equilibrium and increases inflation. As the country cannot adjust its nominal interest rate (as it is set by the CCA monetary authority), this higher inflation will reduce the real interest rate. The government will respond with a contraction of government spending, to create the desired negative output gap as prescribed by the PR curve. The real exchange rate will also become more appreciated
due to this period where home’s inflation is above world (or CCA) inflation. The government will continue to adjust government spending to guide the economy along the PR curve and back to equilibrium. Once back at equilibrium, the economy will have an appreciated real exchange rate and a primary government surplus. This is because the demand shock cannot be totally countered by the appreciation of the real exchange rate as it is in a small open economy with flexible exchange rates. The real exchange rate also experiences some nominal appreciation in the flexible exchange rate regime, but this is not possible in a fixed exchange rate regime (or a CCA).
Monetary Policy Discussion:
- ECB is the single monetary policy () maker in the Eurozone.
- Independently sets using the interest rate to achieve its price stability target ( close to but below 2%)
- Asymmetric target (‘below 2%’) contrasts with other independent CBs & was criticized for increasing the susceptibility to deflation.
- Decision on made using 2 ‘pillars’: Economic pillar (using forecasts of & in decision); Monetary pillar (using broad money growth rate in decision)
- ECB’s performance was broadly successful (stable just above 2% target).
Fiscal Policy:
- SGP specifies limit on national budget deficits (< 3%) and on govt. debt – to – GDP ratio (< 60%).
- Rationale on limits – spillovers from national policy to Eurozone:
- 1: Incentive in small country to run budget deficit to boost and cut → If all members do this, ↑ → ECB has to raise .
- 2: If default risk rises for one member (e.g. in Greece due to deficits) → Contagion to other members.
- Compared to success, was less successful. The SGP was breached by a number of countries and was later revised to discourage pro-cyclical .
Overall, there is free reign in this assignment, implement credible arguments that demonstrate you understand the economic theory behind the Eurozone, discussions about Exchange rates, fiscal policy, the 2008 financial crisis, and inflation rates for example. As long as the theoretical underpinning is sound and demonstrates a clear understanding, the arguments made should be strong.
There is opportunity to use graphs from other sources or perhaps graphs that you wish to implement such as inflation rates/exchange rates over a number of years, if you do use graphs from other sources just put the author, date and page number so I can find it later, stats and graphs would help the arguments in this particular part of the assignment as it will provide an empirical reinforcement of points.
No long sections that are copy and pasted within the main body, once maybe but otherwise just paraphrasing please with citations, emphasis on critical analysis is needed, long sections that are copy and pasted are not that valuable with regards to that.
I will leave a few sources below that I have found and could be useful.
*Fiscal rules in the euro area and lessons from other monetary unions: https://www.ecb.europa.eu/pub/economic-bulletin/articles/2019/html/ecb.ebart201903_02~e835720b96.en.html
EURO AREA FISCAL POLICIES AND THE CRISIS: https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp109.pdf
Solving the Financial and Sovereign Debt Crisis in Europe: https://www.oecd.org/finance/financial-markets/49481502.pdf
*Europe’s Debt Crisis, Coordination Failure, and International Effects: https://www.adb.org/sites/default/files/publication/156225/adbi-wp370.pdf
Fiscal Politics in the Euro Area: https://ideas.repec.org/p/imf/imfwpa/2017-018.html
*Symbiosis of monetary and fiscal policies in a monetary union: https://doi.org/10.1016/S0022-1996(02)00048-X
Monetary and fiscal policy interactions in a micro-founded model of a monetary union: https://doi.org/10.1016/j.jinteco.2005.03.001
MONETARY AND FISCAL POLICIES INTERACTION IN MONETARY UNIONS: https://doi.org/10.1111/joes.12194
*Fiscal policy coordination in the EMU: https://doi.org/10.1016/j.jpolmod.2007.04.007
*Economic and fiscal policy coordination after the crisis: is the European Semester promoting more or less state intervention?: https://www.tandfonline.com/doi/full/10.1080/07036337.2020.1730356
International Fiscal Policy Coordination and Economic Growth: https://doi.org/10.2307/2526893
Fiscal Policy in the New Open Economy Macroeconomics and Prospects for Fiscal Policy Coordination: https://doi.org/10.1111/j.0950-0804.2005.00268.x
General Aspects of Monetary and Fiscal Policy Coordination: https://www.cbcg.me/slike_i_fajlovi/fajlovi/journal/vol2/no3/general_aspects_coordination.pdf
*Trade Imbalances and Fiscal Policy in the Eurozone: An Analysis of Economic Interrelations with a Global Supermultiplier Input-Output Model: https://academic.oup.com/cje/article-abstract/43/2/311/5004811
Does Fiscal Policy Help Those Who Need It Most? Evidence from the US and the Eurozone: https://doi.org/10.1080/1226508X.2012.655027
These are just some of the articles I have found, a * next to the ones that I thought were the most valuable and well written at first glance, please cite as follows (Name, Year, Page number), any other sources you find just put at the end of the document so I can find it easily, only include sources from credible places please.
Q2. Critically examine whether the Taylor rule continues to be a useful tool in shaping monetary policy (1500 Words)
Core Information: Carl & Soskice (2015) Textbook – Macroeconomics: Institutions, Instability, and the Financial System, Relevant Chapter: 13- Monetary Policy
- Assess the following statement: “asset price bubbles played a major role in the global financial crisis, so central banks should have stepped in to burst them in their early stages”.
It is a source of much contention in macroeconomic and policy circles as to whether central banks should intervene to burst asset price bubbles, such as the dot-com boom in the late 1990s or the sub-prime mortgage boom in the mid-2000s. Asset price bubbles are seen as undesirable because they distort resource allocation, affect the central bank’s target variables (e.g. inflation and output) both now and in the future; and can cause financial instability. Whether a central bank should step in to burst bubbles in their early stages depends on three main elements:
- being able to identify bubbles before the financial markets,
- refraining from identifying bubbles that do not exist; and
- bursting bubbles without causing excessive damage to the wider economy.
It is debatable whether central banks can correctly identify bubbles. But even if they were able to do so, the interest rate seems a very blunt tool to go about it. It is also not clear that a moderate rise in interest rates would be sufficient to burst a bubble. The bubble in US sub-prime mortgage markets that led to the global financial crisis was not foreseen by the majority of central bankers, investment bankers or economists. Other policy instruments and or regulation are required.
- Explain how the Taylor rule could find the best response nominal interest rate to be negative.
The Taylor rule for the nominal interest rate is:
It is possible to estimate a Taylor rule for Japan, Eurozone and the US, assuming to be the average policy rate between 1999 and 2011, γ1 to 1.5; and γ2 equal to either 0.5 or 1. Such Taylor rule will predict negative nominal interest rates during the global financial crisis period. Indeed, inflation went below target and output was lower than equilibrium.
- Assess the following statement: “during the financial crisis central banks significantly expanded their balance sheets through quantitative easing and this did not cause inflation expectations to become less firmly anchored to the inflation target, thus we can say that QE does not pose a danger to macroeconomic stability.”
It is certainly true that QE implied a rapid expansion of central bank balance sheets. Under conditions of a deep recession, QE was intended to boost inflation expectations. This was viewed as a necessary step to guard against deflation in the midst of the financial crisis. The fact that inflation expectations remained anchored to target may suggest that the main potential drawback of QE proved to be wrong. Nevertheless, there are still a number of key dangers of undertaking quantitative easing:
- Central bank independence and credibility. QE involves the extension of the central bank remit into areas characterized by high political interference. If this led to a perceived reduction in credibility, then inflation expectations could become less firmly anchored to the inflation target and stabilization policy could become more costly.
- Financial cycle. There is a danger that under conditions of prolonged low interest rates and official asset purchases, the search for yield will re-emerge to inflate housing and other asset price bubbles in the global economy.
- Excess reserves.
- Exit. The policy of quantitative easing is not unwound when the central bank stops purchasing assets, but rather when the assets accumulated on the central bank’s balance sheet mature or are sold back into the market. This could pose dangers for both inflation (by putting downward pressure on it) and macroeconomic stability.
- Evaluate the following claim: “higher capital ratios for banks are costly for society as they increase banks’ cost of capital.”
Higher capital ratios make banks safer and reduce the chance of failure of a systemically important bank, the threat of a financial crisis and the need for a state bail-out. However, such policy would also come at some cost. Having a higher capital ratio means that banks would have to finance a higher proportion of their business with equity rather than with debt. According to the Modigliani Miller (MM) (1958) theorem, under certain conditions, the overall cost of finance to a firm does not depend on the balance of financing between debt and equity. It is not straightforward, however, whether the theorem can be applied to banks too. The direct application of MM to banks would say that the argument that higher capital ratios would raise the cost of capital to banks ignores the effect of a higher capital ratio in reducing risk: with lower risk, equity holders would require a lower rate of return and overall funding costs would be unchanged. From a social cost perspective, the mix of banks is not irrelevant. Acting in their own self-interest, banks will choose a lower than socially optimal capital ratio. The public suffers if the share of equity is too low (leverage is too high) because of the greater risk of financial crisis and of state bail-out. If the capital ratio is raised, this reduces the taxpayer liability (in the event of insolvency) and increases the private cost of capital. By reducing the potential liability of the government, the cost of finance to the government goes down but goes up for the private bond and shareholders of the bank. As John Vickers pointed out, ‘MM might
hold taking the public and private sectors together, while it fails for the private sector in isolation’.
Can the Taylor rule be a good tool to analyse the monetary policy quality at the time of recent market turbulences ?: http://cejsh.icm.edu.pl/cejsh/element/bwmeta1.element.cejsh-element-000171453285
Monetary Policy as Financial Stability Regulation: https://academic.oup.com/qje/article-abstract/127/1/57/1833092
Challenges for Monetary Policy: New and Old: https://www.bankofengland.co.uk/-/media/boe/files/speech/1999/challenges-for-monetary-policy-new-and-old.pdf
The Taylor Rule: A Useful Monetary Policy Benchmark for the Euro Area?: https://doi.org/10.1111/1468-2362.00020
Friedman and the Bernanke-Taylor Debate on Rules versus Constrained Discretion: https://heinonline.org/HOL/Page?collection=journals&handle=hein.journals/catoj36&id=314&men_tab=srchresults
The Taylor Rule and the Practise of Central Banking:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553978
Taylor rules with real-time data: A tale of two countries and one exchange rate: https://doi.org/10.1016/j.jmoneco.2008.07.003
How Useful Are Taylor Rules for Monetary Policy?: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.296.428&rep=rep1&type=pdf
The Taylor Rule: A Guidepost for Monetary Policy? http://php.scripts.psu.edu/users/r/x/rxc122/the%20taylor%20rule%20a%20guidepost%20for%20monetary%20policy%20pdf.pdf
