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EU MONETARY AND FISCAL POLICY TOPICS IN ECONOMIC POLICY SPRING 2009 - JMU. WEEK 1 HISTORY OF EU INTEGRATION AND THE BASIC MACRO TOOLKIT Prof. Luigi Marattin. 1)A FLAVOUR OF EU HISTORY. EU, from an economic point of view, is a three-floor building. First floor : Custom Union (1957) - PowerPoint PPT Presentation



  • 1)A FLAVOUR OF EU HISTORYEU, from an economic point of view, is a three-floor building.First floor: Custom Union (1957)Second floor: Economic Union (1993)Third floor: Monetary Union (1999)Foundations are peace and prosperity (Treaty of Rome, 1957).

  • The aim of the processEU integration is a political process with a political end: economics is just a mean to that end.Dont make the same mistake almost everyone has made in the past 50 years:DONT FORGET THAT

  • FIRST FLOOR: CUSTOMS UNION25th March 1957A group of countries which: a) abolish trade restrictions (tariffs, quotas, duties,imports limits, etc) among themselves b)mantain a common external tariff towards external countriesWhy? It is a middle-ground option between:Protectionism (high prices for consumers, no incentive to efficiency, innovation and growth)Immediate global free trade (if the countrys economy is recovering, or anyway too weak, it can destroy the internal supply-side structure)

  • It allows counties to design a joint path for growth and efficiency, meanwhile mantaining a common and temporary protection towards more efficient economies.

    Succesful experience: customs union developed all over the words (Africa, Arab Countries, NAFTA, EFTA)

    What does temporary mean?That when the joint path for growth and efficiency is over, countries should open their economies to global free trade.Did this happen? WTO (failure of the Doha Round, started in 2001) and todays debate (US Vs EU Vs emerging economies).

  • SECOND FLOOR: ECONOMIC UNION: 1st January 1993A customs union plus:- ban of non-tariff barriers (non-economic impediments to trade)- free movement of productive factors (capital and labour).A COMMON MARKETSince January 1 1993: - European citizens can invest (financial and real capital) with no limitations all over EU - they can move and work all over EU with no visa and work permit required (temporary limitations for new member states)

  • Why?The bigger the size of the market:- the lower the price level (competition)- the lower the cost structure for firms (scale economies)- the higher the productivity (Darwin-like)- the higher the incentive to efficiency and innovation- the higher the learning-effect- the higher the (potential) growth rate

    Are there any risks?- crowding-out effect for workforce- who actually likes (and benefits from) competition and market integration?

  • THIRD FLOOR: MONETARY UNION1st January 1999EU in the early 90s: a big supermarket where you had to change currency every time you changed shop.

    One market, its currency.

    All this course will be concerned with the explanations of the steps up from second to third floor.

  • Some historyWhere did the idea come from? 1957: Italy, France, Germany, Netherlands, Belgium, Luxembourg First enlargement: UK and Ireland (1973)Second enlargement: Greece (1981), Spain and Portugal (1986)1992: Second floor: economic union (UE)Third enlargement: Austria, Sweden, Finland (1995)1999: Third floor: monetary union (EMU)Fouth enlargement: Eastern countries (2004 and 2007)

  • EU today has 27 members states.16 of them (Slovakia from 1/1/09) are part of EMU.Negotiations to enter EU are in progress with: a) Croatia b) Macedonia c) Turkey (interrumpted on 11/2006)Possible future member states: a) Serbia, Bosnia. Montenegro b) AlbaniaIn week 6 well talk about the different criteria to be admitted into EU and EMU.

  • 2) BASIC MACROECONOMIC TOOLKIT2.1. Monetary policy2.2. Fiscal policy2.3. Exchange rate policy


    Lets have a look at each of those from the (very basic) theoretical point of view.

  • The most important identity in macroeconomicsY = C + I + G + X IMY = national income (production, GDP)C= aggregate consumptionI = gross investment (included inventories)G = government expenditureX = exportsIM = imports

  • Y = aggregate supply (= f (K,L,A))C+I+G+X-IM= aggregate demandWhatever is produced (using capital, labor and total factor productivity) gets demanded by someone:- the public sector (G) for public purchases- the private sector, to be consumed (C)- the private and public sector, to be invested (I)- the foreign sector (NX: net exports) Macroeconomic policy affects aggregate demand through the effects of the three branches on each of the above component (C,I, G, NX).Thats what macroeconomic policy is for: to regulate aggregate demand, and therefore the level (or the growth) of GDP.

  • 2.1. Monetary policyWe define monetary policy the actions aimed at regulating the quantity (and the price) of money into the economy.

    Whats money for?a) means of exchange (how do we trade my computer with a IPhone?)b) unit of accounts (how much is this pen?)c) store of value (how can I store my savings?)

  • James Tobin (Nobel Prize winner): Money has the same source of legittimacy than languageWhos in charge for monetary policy?Central Banks - Federal Reserve System (Fed) - European System of Central Banks (Ecb) - Bank of England - People Bank of China - Bank of Japan Central Banks are the only institutions allowed to print and in the first place- distribute money.

  • How do they do monetary policy?(later in the course (week 4) well go in greater detail)By moving the short-term interest rate.

    The interest rate indicates the (most evident) price of money: 1) Its what I have to pay in order to borrow a given quantity of money (mortgage, etc)2) Its what I give up in order to be able to hold money in my pocket (= liquidity) : opportunity cost.

    Raising the interest rate makes money more expensive (so it cools down the economy)Decreasing the interest rate makes money cheaper (so it boosts the economy)

  • Imagine the interest rate family: long-term interest rateTreasury bonds interest rate (at different maturities) Interest rate on bank depositsInterbank interest rateOvernight interest rateInterest rate swap

    Many of the above are governed by the fundamental law of economics: demand and supply.But each of them is linked (more or less directly) with the granfather of the family: the short-term interest rate moved by the central bank

  • And which one is that?!

    Interest rate on federal funds (US)Interest rate on main refinancing operation (EU)

    By moving these fathers (thereby making money more or less expensive at the source), central banks affects the quantity (and the price, obviously) of money in the overall economy, also through the functioning of the children and grandchildren.Do children and grandchildren always respect the GodFather.?!?! (current financial crisis).

  • When CB moves the interest rate (i) it affects C and I.An increase in the interest rate:a) decreases C (savings are more convenient)b) decreases I (borrowing money for investment is more expensive; furthermore, financial investment are more convenient)

    So a restrictive monetary policy (= interest rate increases) decreases aggregate demand via the negative effect on C and I, thereby cooling down the economyAn expansionary monetary policy (=interest rate decreases) goes the other way round (it boosts the economy).

  • Why would CB want to raise/decrease the interest rate?CB reacts to two macroeconomic variables:a) output gap (actual output minus potential output)b) inflation

    a) When output increases above potential (economy is good), CB raises interest rate (to cool it down) When output is below potential (economy is bad), CB decreases interest rate (to close the gap)b) When inflation is above target, CB raises interest rates (to fight inflation) When inflation is below target, CB decreases it.

  • When CB reacts to a demand shock (Y up, P up) the receipt is simple: raise i, in order to cool down the economy and bring inflation down.Things are more complicated after a supply shock (Y down, P up): in that case, CB has to choose between which objective it cares the most about: a) stabilizing output (bring Y up) b) stabilizing inflation (bring down)a) implies a decrease in interest rateb) implies an increase in interest rate (THE MOST IMPORTANT) MACROECONOMIC POLICY DILEMMALately, CB main concerns have been about inflation.CBs job: to fight inflation. And whos in charge for output stabilization?

  • 2.2. Fiscal policyFiscal policy is concerned with the management of:a) public expenditure (G and Tr)b) direct and indirect taxation (T)In Week 9 well go in deep about b)In most of the course well go in deep about everything regarding fiscal policy:- fiscal policy aggregate measures (deficit, primary deficit, cyclically adjusted deficit, public debt)- fiscal policy rules and their role- interaction with monetary policy

  • As for now, you just have to frame fiscal policy into the right picture:Y = C+ I + G + NXFiscal policy affects aggregate demand through:1) Direct effect: G (and also I)2) Indirect effect: C= f (T, Tr)Taxation decrease consumptionTransfers increase consumption

    Obviously the indirect effects depend upon: a) the marginal propensity to consume b) expectations on future fiscal policy stance (permanent income hypothesis)

  • So we define:Expansionary fiscal policy: a) decrease in T b) increase in G c) increase in Tr Restrictive (contractionary) fiscal policy: a) increase in T b) decrease in G c) decrease in TrExpansionary fiscal policy is used to increase output (to fight recessions and downturns) and increase public debt.Contractionary fiscal policy is used to calm down output (to prevent inflationary pressures) and reduce debt.

  • Whos in charge for fiscal policy?Governments (national, local).

    So bear in mind: fiscal policy reacts to: a) output b) stock of public debt

    Increasing taxes (or reducing expenditure) reduces b) (which is good), but also reduces a) (which is bad). And vice-versa.This is all traditional. Is the current crisis gonna change something?

  • So far we have seen the two main arms of macroeconomic policy, sketching the resulting division of labor:Monetary policy: a) uses interest rate (=price of money) b) affects consumption and investment c) fights inflation (and also recessions)Fiscal policy: a) uses G, T and Tr b) affects directly G, and indirectly C c) fights recessions (and manage debt)But we dont live in closed economies.

  • 2.3. Exchange rate policyAn economy is open if there is an exchange of goods, services and capital flows with abroad.X = exportsIM = importsNX = X-IM = net exportsNX = f (E)E = nominal exchange rate

  • E = price of national currency in terms of foreign currencya) For EU citizens: how many dollars does it take to buy one euro? 1.50b)For US citizens: how many euro does it take to buy one dollar? 0.66

    Not surprisingly, 1/1.50 = 0.66

    Well (have to) reasons as a). Get familiar.

  • How does E affect aggregate demand?If E increases:It takes more units of foreign currency to buy the same 1 national currencyNational currency appreciatesExports (X) are more expensiveImports (IM) are cheaperNX decrease, aggregate demand decreases

    So an appreciation reduces aggregate demand (it cools down the economy), at the expenses of the exporting sector and benefiting whatever depends on imports (fuel, etc).

  • If E decreases:It takes less units of foreign currency to buy the same 1 national currencyNational currency depreciatesExports (X) are cheaperImports (IM) are more expensiveNX increase, aggregate demand increases.

    A depreciation increases aggregate demand (it boosts the economy), at the expenses of whatever depends on imports, and benefiting the exporting sector.

  • What determines the value of E?a) Flexible exchange rate regimeb) Fixed exchange rate regime

    a) E is determined by the demand and supply of currencies (people selling euro and buying dollars to travel in the US put their infinitesimaly small upward pressure on the dollar). In this case exchange rates are extremely volatile.b) E are fixed by bi/multilateral agreements between governments and CBs. Whatever pressures (coming from financial market integration) must be offset by CBs.Examples. The crucial role of the interest rate.

  • a) Pros and b) ConsFixeda) Stability of exchange rates (good for investors, growth)b) Monetary policy cannot be used for internal purposes (fighting inflation and recessions) because it must be used for external purposes (maintain E)Flexiblea) Macroeconomic policy is fully loaded.b) High volatility of exchange rates (are you willing to invest in argentinian bonds, or to build a factory in Ukraine? Or even across the Atlantic.)

  • A very important remarkThere is another cost of having fixed exchange rates, and most of this course will be about it.Three prices (what do I give up in order to have it in my pocket?) of currency:a) towards itself: what I give up tomorrow to have it today: interest rateb) towards goods and services: what I give up in terms of purchasing power: inflation ratec) towards foreign currency: what I give up in terms of foreing currency (holding 1 euro in my hands costs me 1.27 dollars): exchange rate

  • Interest rate (i), inflation rate () and exchange rate (E) are three sides of the same coin: they whole indicate the price of money towards something.

    Not surprisingly, if I want to hold one of them fixed (like E, in a fixed exchange rate regime), in one way or another Ill have to harmonize also the remaining two.

    Welcome to your first understanding of the Maastricht criteria (how to form a Monetary Union), Week 5 and 6.

  • Sum up: macroeconomic policy in a nutshellY=C + I+ G + NXMonetary policy: a) Managed by central banks b) Moves the short term interest rate c) Affects C and I d) Responds to inflation (and output) Fiscal policy: a) Managed by governments b) Moves G, T and Tr c) Affects G, I (it is them!), C d) Responds to output and debt

  • Exchange rate policy: a) Only in fixed regime (otherwise its governed by demand and supply of currencies) b) Managed by governments / CB c) Moves E d) Affects NX and inflation (imports can become cheaper or more expensive) e) Responds to current account deficit (US throughout this decade)

  • Are there any interactions between these arms?1) MP / FP:If MP increases i, the debt services (government interest payments) increases, thereby increasing government expenditure2) MP/EPIF MP increases i, financial investment in that country become more convenient; capital inflows, demand for that currency increases, E appreciates.THIS CANNOT HAPPEN WHEN...