Recap questions chapter 1
See the questions at page 23 of your coursebook.
Additional questions:
1. Explain how wage flexibility allows countries to reduce the cost of a monetary union
when an asymmetric demand shock occurs. Illustrate graphically in a AD-AS model.
In a monetary union, if there is a permanent shift in consumer preferred consumption from
products/services France to products/services of Germany (that is, an asymmetric shock in
demand), the cost of being in a MU can be reduced with either wage flexibility or labour
mobility. Indeed, if wages are flexible, the unemployment in France will reduce wage claims in
France (aggregate supply in France shifts downwards). Whereas, in Germany, the excess demand
for labour will raise wage claims in Germany (aggregate supply shifts upwards). In France, the
price output declines and makes their products more competitive, while the opposite occurs in
Germany. Moreover, real wage in France declines, which leads to decrease in aggregate demand.
Furthermore, there is a second-order impact on aggregate demand: Wages impact prices, and
product prices impact competitiveness. e.i. Price increase in Germany make French products
more competitive. French agg. demand goes up again and higher prices in Germany decrease
their agg. demand.; and real income impacts private consumption.
, 2. Explain how distrust about the solvency of a MU member state can amplify the effects
of asymmetric demand shocks, lead to a liquidity crisis that can become a solvency
crisis. What happens in the money market, in the bonds market, in the exchange
market? What would happen if the country were not in the monetary union?
If, for example, investors fear default of the Belgian government, investors will sell Belgian
government bonds and withdraw liquidity from the national market. The interest rate will
increase. And the proceeds of these sales in euro will be used to invest in other eurozone
countries, but Euro will not depreciate since the investors will reallocate their portfolios within
the euro area sovereign bond asset class. Because Belgium is in a MU, it cannot stop this with a
floating exchange rate. Thus, the Belgian money stock will decline, and the pool of liquidity for
investing in Belgian bonds shrinks. A liquidity crisis is possible, as the Belgian government
would not be able to guarantee to pay out cash to holders of government bonds and cannot force
the ECB to buy Belgian government bonds. The liquidity crisis can turn into a solvency crisis
if the money is pulled out of the national market to the point where the primary surplus becomes
lower than the difference between the nominal interest rate and the nominal growth rate times the
debt ratio. The country becomes insolvent because investors feared insolvency (self-fulfilling
prophecy). Governments will be forced to reduce spending and increase taxation (budgetary
austerity), which will increase the political burden.
If the country were not in the MU (if it were a stand-alone country), this interaction between
liquidity and solvency would be avoided. Investors would sell national government bonds but no
“sudden stop” would occur, because investors would exchange the proceeds of the government
bond sales (in national currency) in the forex market. The national currency would thus
depreciate, and the national money market would remain unchanged. Part of this money stock
will probably be reinvested in national government securities. And if that is not the case, the
Central Bank could be forced by the national government to buy government bonds, to provide
liquidity, to pay out cash to holders of government bonds.
3. Alternative to 3.: Explain carefully why the spread of the Spanish/Greek/italian
government bonds became very high in 2010-2011.
The spread of government bonds refers to the difference in yield or interest rates between the
bonds issued by a particular government and the benchmark government bonds (usually those of
a stable and economically strong country, like Germany or the United States). A higher spread
indicates that investors perceive higher risk associated with the bonds issued by a particular
government. In the context of the 2010-2011 period and the Spanish, Greek, and Italian
government bonds
In 2010-2011, during the solvency crisis, Spanish/Greek/Italian governments had a very high
‘debt to GDP ratio’ due to sharp decline in GDP. Which means government bonds were riskier.
Long-term government yields diverged due to different risk premia for the risk of default.
Financial markets lost confidence in southern Eurozone countries and as a result they sold the
government bonds of these countries, increasing interest rates. Higher interest rate further
decreased economic activity, led to stagnated GDP growth, and therefore increase in debt-to-
GDP ratio.
