Final Exam
3 questions:
 Question 1 (20%). No choice
 Question 2 (40%). Answer 8 out of 10
short questions. ONLY THE FIRST 8
ATTEMPTED ANSWERS IN YOUR ANSWER BOOK
WILL BE GRADED

Question 3 (40%). Answer 2 out of 4.
ONLY THE FIRST 2 ATTEMPTED ANSWERS IN
YOUR ANSWER BOOK WILL BE GRADED
Topic 3: Adjustment within the euro
area



European Monetary Union (EMU) launched
in 1999
Ireland adopted the euro
Interest rates in the euro area set by the
European Central Bank (ECB)

ECB’s target is to keep average euro-area
inflation below, but close to, 2 percent
Pros and Cons of joining EMU

Pros


Lower risk premium on interest rates 
greater investment  higher income
Cons

Domestic interest rates and exchange rate no
longer respond to shocks to the Irish
economy
Optimal Currency Area (OCA)


Members can perform well using a
common currency
Asymmetric shocks

Shocks that affect some economies but not
others, or common shock that affects
economies in different ways
Joining a common currency area

Costs of joining a common currency are
lower when:



Fewer asymmetric shocks
Greater factor mobility
Both characteristics help to prevent actual
output from deviating too much or for too
long from potential output
Asymmetric shocks

When bad shocks hit a country that is not
part of a currency union:



Central bank cuts interest rates to spur
domestic demand
Exchange rate depreciates which helps to
boost international competitiveness
Opposite occurs when good shocks hit
Asymmetric shocks


Euro-area interest rates and the euro
exchange rate will respond to common
(symmetric) shocks to the euro area
But they will not respond to asymmetric
shocks that hit Ireland
Real interest rate channel

Real interest rate
r = i – pe
where
r = real interest rate
i = nominal interest rate
pe = expected inflation
Real interest rate channel
Low real interest rates boost economic
activity
 High real interest rates depress economic
activity
Dilemma: faster growing members of EMU
may have higher inflation rates and
thereby face lower real interest rates

Divergence
Divergence in inflation rates  divergence
in economic performance  further
divergence in inflation rates  … etc.
Divergence in the euro area



Dispersion of inflation much lower during
EMU than in early 1990s. Similar
dispersion to the United States
Growth dispersion not unusually large
However, both inflation and growth
dispersion are persistent
Sources of euro-area divergence

Convergence





nominal interest rates
price levels (though mostly pre-EMU)
Balassa-Samuelson effect
Asymmetric shocks
National policies

Pro-cyclical fiscal policy
Factor mobility

Labour and capital move to booming
region, boosting supply of output in that
region
 reduces overheating pressures

Labour and capital move out of depressed
region, reducing supply of output in that
region
 reduces excess capacity
Real exchange rate channel


If faster growing members of EMU have
higher inflation rates  real effective
exchange rates are appreciating 
dampens export growth
Converse holds for slower growing
members of EMU
Real exchange rate channel



This channel requires price and wage
flexibility
Does not have much effect on relatively
closed economies
Can take a long time to operate
Cross-country fiscal transfers

The euro area lacks a cross-member fiscal
transfer mechanism that could help to
reduce divergences
National fiscal policy


EMU works best if member countries avoid
pro-cyclical fiscal policy
Stance of fiscal policy measured by
cyclically-adjusted (structural) fiscal
balance

(Actual) budget balances automatically rise
during booms and fall during recessions
Structural fiscal balance


Improvement of the structural fiscal
balance implies fiscal contraction
Deterioration of structural fiscal balance
implies fiscal expansion
Comments

Overall balance = current balance +
capital balance


Government is running a large capital deficit
Overall balance = primary balance –
interest payments
Fiscal policy

Sustainability of EMU put at risk if national
governments do not run counter-cyclical
fiscal policies


Loosen fiscal policy when times are bad, and
tighten when things are good.
Stability and Growth Pact (SGP) limits
fiscal deficits to 3% of GDP

Some members are violating rule
Fiscal balance


Government medium-term objective is to
have the fiscal position close to balance
Arguments for large fiscal surplus in the
short term


Room to manoeuvre if bad shock hits
Future age-related spending pressures

National Pension Reserve Fund