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Economic Policy in the EU - Lecture 5 (2020)
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Lecture 5, Economic Policy in the EU.
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Exchange rates and monetary integrationMacroeconomic policy has a few goals.
• Primarily governments are concerned with full employment. Employment has a lot of
benefits, financial, emotional, contributing to the economy.
• Another goal is price stability: prices should not change too much over time. Because
it then creates predictability, which is nice for investors for example. Investing is
already a risk, so you can’t also have the risk of price instability.
• Economic growth, increasing the output year after year
• Balance of payment equilibrium, export and import are more or less the same
Means to achieve these goals:
• Fiscal policy, which means government expenditures and taxes
• Monetary policy, which means interest rates and an open market
• Exchange rate policy, which means you either fix your exchange rate or not, and if
you fix it, you need to decide which parity you are going to use.
There is a close interaction between these means, which makes it harder to use these policy
instruments.
- With floating exchange rates, fiscal policy becomes more difficult
- With fixed exchange rates, monetary policy becomes more difficult
è The decision to create either fixed or floating exchange rates affects the way in which
you can achieve goals through monetary or fiscal policy.
- Expansionary fiscal policy means that governments spend more than they receive in
taxes and they need to borrow money. This affects interest rates. Interest rates are
very much related to monetary policy
- Loose (or tight) monetary policy may affect the interest rates as well. Which may
affect investments, which is typically in the range of creating full employment.
Fiscal policy
Fiscal policy is to manage aggregate demand. Aggregate demand = total consumption, total
investments, total government expenditure and net exports (which is total exports minus
total imports è Y = C + J + G + NX. This is the most common way to show aggregate
demand. Y is your production, your GDP. If Y is higher, you need more people to work. Y is
very often related to the full employment income (the income that creates full
employment). So if Y is lower than the full employment income, the government tries to
increase government expenditures, which increases income. Income can also be too high for
full employment. People are then working overtime, you would then like to see the
government reduce government expenditure a bit. Instead of government expenditures,
taxes can also be used. This works indirectly however. Reduced taxes usually drive up
consumption, but this is an indirect measure.
Monetary policy
Monetary policy typically tries to manage the supply of money. The demand for money is
often more independent of your policy. You increase or decrease money supply to try and
achieve price stability. The money supply and interest rate are things you can manipulate
with monetary policy. There are different types of interest rates, but these are all linked by
the interest rate given by the central bank.
, The interest rate is the price for money. This is why, the supply of can be managed by
manipulating interest rates. With the interest rate, the central bank can also influence
investments. When the interest goes up, investments go down, because it is more difficult to
get financing for your investment and at the same time you can make more money by
putting your money in the bank.
In an open economy, which many countries in the EU are, interest rates also affect exchange
rates.
An exchange rates is the price of a currency in terms of another currency. If there is a higher
demand for €, the euro becomes more valuable. This higher demand could occur when the
interest rate in the EU is higher than elsewhere. This means people from other countries
want to get euros to put in EU banks because they get a higher interest rate in the EU. Inflow
of capital can lead to inflation (to some extent). If the EU exports more than it imports, there
is more demand for euros to pay for these exports, which also leads to an inflow of currency
in that country, which could again lead to higher prices.
Exchange rates always get to an equilibrium. For example: 2,5% interest rate in EU, 1,5%
interest in the US. This leads to more demand for the EU currency, which makes that
currency go up initially. After a year however, the Euros need to be paid back with interest,
which leads to a higher supply of euros. This makes the exchange rate go down again.
Interest rate parity: it doesn’t matter where you put your money, eventually it will all go up
and down. Same goes for the purchasing power parity: it doesn’t matter where you buy
your products. The basket of products should not matter that much. If the basket is very
cheap in one country and expensive in the other, you will see demand going up in the cheap
country and going down in the expensive country. This is a result of people buying from the
cheap country and selling in the expensive country. You need to buy in the cheap country
with that currency. This makes for a higher demand for that currency. You are going to sell in
the expensive country, which means there is a higher supply of that currency there. Through
the currency you see that prices becomes equilibrated over time. So, the exchange rate
moves towards interest rate parity and/or purchasing power parity.
An appreciation of the dollar means: $/€ goes down, or €/$ goes up. This makes American
products more expensive for Europeans. American products can also get more expensive in
dollars. This also makes American products more expensive for Europeans. Price movements
can affect trade. If an American product becomes more expensive, this leads to less demand
for this product from the EU. This then leads to a lower demand of dollars, which leads to a
lower price for dollars. Countries with high inflation usually see a depreciation of their
currency.
The real exchange rate is the rate of one basket of goods for another basket of goods. How
many European baskets can you buy for one American baskets? You then deal with both
prices and exchange rates.
The real exchange rate gives you an index number. A higher number means a real
appreciation. If you need 1,5 EU basket for 1 US basket, means a real appreciation of the
US$. Over time, these baskets will show a fairly stable exchange rate. Inflation (higher prices)
leads to depreciation. A real appreciation will lead to lower competitiveness. This in turn will
lead to a balance of payment deficit. As a result, prices will go down or a depreciation of the
currency takes place.
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