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

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

2. 1)A FLAVOUR OF EU HISTORY • EU, 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).

3. The aim of the process • EU integration is a political process with a political end: economics is “just” a mean to that end. • Don’t make the same mistake almost everyone has made in the past 50 years: • DON’T FORGET THAT

4. FIRST FLOOR: CUSTOMS UNION25th March 1957 • A group of countries which: a) abolish trade restrictions (tariffs, quotas, duties,imports limits, etc) among themselves b)mantain a common external tariff towards external countries Why? 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 country’s economy is recovering, or anyway too weak, it can destroy the internal supply-side structure)

5. 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 today’s debate (US Vs EU Vs emerging economies).

6. SECOND FLOOR: ECONOMIC UNION: 1st January 1993 • A customs union plus: • - ban of non-tariff barriers (non-economic impediments to trade) • - free movement of productive factors (capital and labour). A COMMON MARKET Since 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)

7. 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?

8. THIRD FLOOR: MONETARY UNION1st January 1999 • EU 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.

9. Some history • Where 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)

10. 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) Albania In week 6 we’ll talk about the different criteria to be admitted into EU and EMU.

11. 2) BASIC MACROECONOMIC TOOLKIT • 2.1. Monetary policy • 2.2. Fiscal policy • 2.3. Exchange rate policy They define MACROECONOMIC POLICY • Let’s have a look at each of those from the (very basic) theoretical point of view.

12. The most important identity in macroeconomics • Y = C + I + G + X – IM • Y = national income (production, GDP) • C= aggregate consumption • I = gross investment (included inventories) • G = government expenditure • X = exports • IM = imports

13. Y = aggregate supply (= f (K,L,A)) • C+I+G+X-IM= aggregate demand • Whatever 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). That’s what macroeconomic policy is for: to regulate aggregate demand, and therefore the level (or the growth) of GDP.

14. 2.1. Monetary policy • We define monetary policy the actions aimed at regulating the quantity (and the price) of money into the economy. • What’s 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?”)

15. James Tobin (Nobel Prize winner): “Money has the same source of legittimacy than language” • Who’s 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.

16. How do they do monetary policy? • (later in the course (week 4) we’ll go in greater detail) By moving the short-term interest rate. • The interest rate indicates the (most evident) price of money: • 1) It’s what I have to pay in order to borrow a given quantity of money (mortgage, etc) • 2) It’s 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)

17. Imagine the “interest rate family”: • long-term interest rate • Treasury bonds interest rate (at different maturities) • Interest rate on bank deposits • Interbank interest rate • Overnight interest rate • Interest 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

18. 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).

19. 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 economy An expansionary monetary policy (=interest rate decreases) goes the other way round (it boosts the economy).

20. 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.

21. 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 π down) • a) implies a decrease in interest rate • b) implies an increase in interest rate • (THE MOST IMPORTANT) MACROECONOMIC POLICY DILEMMA • Lately, CB main concerns have been about inflation. • CB’s job: to fight inflation. And who’s in charge for output stabilization?

22. 2.2. Fiscal policy • Fiscal policy is concerned with the management of: • a) public expenditure (G and Tr) • b) direct and indirect taxation (T) • In Week 9 we’ll go in deep about b) • In most of the course we’ll 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

23. As for now, you just have to frame fiscal policy into the right picture: • Y = C+ I + G + NX • Fiscal policy affects aggregate demand through: • 1) Direct effect: G (and also I) • 2) Indirect effect: C= f (T, Tr) • Taxation decrease consumption • Transfers increase consumption • Obviously the indirect effects depend upon: a) the marginal propensity to consume b) expectations on future fiscal policy stance (permanent income hypothesis)

24. 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 Tr Expansionary 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.

25. Who’s 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?

26. 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 don’t live in closed economies.

27. 2.3. Exchange rate policy • An economy is open if there is an exchange of goods, services and capital flows with abroad. • X = exports • IM = imports • NX = X-IM = net exports • NX = f (E) • E = nominal exchange rate

28. E = price of national currency in terms of foreign currency a) For EU citizens: how many dollars does it take to buy one euro? 1.50 b)For US citizens: how many euro does it take to buy one dollar? 0.66 • Not surprisingly, 1/1.50 = 0.66 • We’ll (have to) reasons as a). Get familiar.

29. How does E affect aggregate demand? • If E increases: • It takes more units of foreign currency to buy the same 1 national currency • National currency appreciates • Exports (X) are more expensive • Imports (IM) are cheaper • NX 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).

30. If E decreases: • It takes less units of foreign currency to buy the same 1 national currency • National currency depreciates • Exports (X) are cheaper • Imports (IM) are more expensive • NX 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.

31. What determines the value of E? • a) Flexible exchange rate regime • b) 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.

32. a) Pros and b) Cons • Fixed a) 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) • Flexible a) 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.)

33. A very important remark • There 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 rate • b) towards goods and services: what I give up in terms of purchasing power: inflation rate • c) 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

34. 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 I’ll 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.

35. Sum up: macroeconomic policy in a nutshell • Y=C + I+ G + NX • Monetary 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

36. Exchange rate policy: • a) Only in fixed regime (otherwise it’s 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)

37. Are there any interactions between these arms? • 1) MP / FP: • If MP increases i, the debt services (government interest payments) increases, thereby increasing government expenditure • 2) MP/EP • IF MP increases i, financial investment in that country become more convenient; capital inflows, demand for that currency increases, E appreciates. • THIS CANNOT HAPPEN WHEN……..? • WHEN WE ARE IN A FIXED EXCHANGE REGIME.

38. 3) FP/MP • If FP stimulates too much aggregate demand (tax cuts, government spending), inflation raises and then MP have to respond to it by raising interest rates. • There are more complicated interaction (FP/EP) but we’ll ignore them for now.

39. NEXT WEEK • When should countries form a monetary union? • What are the consequences and the risks? • OCA theory (week 2 and 3) , ch. 1,2,3,4.