EU MONETARY AND FISCAL POLICY TOPICS IN ECONOMIC POLICY – SPRING 2009 - JMU

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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

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  • EU MONETARY AND FISCAL POLICYTOPICS IN ECONOMIC POLICY SPRING 2009 - JMUWEEK 1HISTORY OF EU INTEGRATION AND THE BASIC MACRO TOOLKIT Prof. Luigi Marattin

  • 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

    They define MACROECONOMIC 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

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