The Interest Gates in Greece, Analysis of Bailout of Greece as a Policy from the Perspective of ECB - Assignment Example

International Economics Assessment – 1 Name (s) 1._______________________________________________________________________ 2.________________________________________________________________________ 3.________________________________________________________________________ Student ID 1._____________________________ 2._____________________________ 3._____________________________ Assessment 1: 1a. The interest rates in Greece were expected to fall. The open market purchases by ECB increased money supply. Excess supply of money caused excess demand for bonds, which in turn raised their prices. Bond prices are inversely related to interest rates (Megginson & Smart 2001); thus, interest rates fell until a new equilibrium was established in the money market. An increase in money supply Interest Rates Ms1 Ms2 6% E 3% F Md 1,000 1,600 Money ($ Billions) Explanation: From the example above, at point E, the money market is in equilibrium at an interest of 6%. When ECB increases money supply, $1600 Billion, the interest rates fall from 6% to 3%. The excess money supply (and excess demand for bonds) would cause bond prices to rise and interest rates to fall until a new equilibrium at point F is established with an interest rate of 3 percent. The expected outcome of this policy on behalf of ECB When ECB increases money supply, interest rates fall. Consequently, spending increases in the economy e.g. on plant and equipment, new housing and consumer durables. Real Aggregate Expenditure ($ trillions) AE r=3% F AE r=6% E 45o 8,000 10,000 Real GDP ($ Billions) A fall in interest rates leads to an increase in investment (Brentani 2004). When there is increased investment particularly on capital goods output of goods and services increases in the economy. According to Wiseman (2013), an increase in the planned investment coupled with an increase in the autonomous consumption through the multiplier effect leads to an increase in Real GDP. Consequently, increased investment leads to creation of more jobs thus increased employment. When there is increased employment it means that people have more disposable income, which increases the aggregate demand for goods. An increase in aggregate demand could lead to prices rising leading to an inflationary situation. “If government of Greece also increases the expenditure (expansionary fiscal policy) then what do you think can potentially happen to prices?” Real Aggregate Expenditure ($ trillions) Price Level AE 2 F AE 1 E AD 2 450 AD 1 10 12.5 Real GDP ($ trillions) 10 12.5 Real GDP An increase in government expenditure may be implemented in many forms such as through salaries and wages to state workers, social security benefits, and better infrastructure – roads and railways, water, and sanitation among others. An increase in government expenditure has an effect of transferring assets to the public (Duggan & Scott 2004; Qi, Shen, & Dou 2013). National income or output can be given by the equation Y = C + I + G + NX where Y is the output or national income, C is consumption spending, I is investment spending, G is government expenditure and NX is the net exports (exports minus imports) (Krugman & Obstfeld 2000). Consequently, an increase in G causes an increase in Y. An increase in expenditure (expansionary fiscal policy) causes an increase in aggregate demand, which has an effect of increasing prices of goods. An increase in government expenditure has an effect of increasing output and in the process creating employment (Palmatier & Crum 2003). An increase in the number of people employed means that there is an increase in disposable income from salaries and wages payment. Consequently, an increase in disposable income leads to a higher aggregate demand, which has an effect of increasing the prices of goods that could lead to an inflationary situation. Do you think that bail out of Greece is healthy policy from the perspective of ECB? Bail out of Greece from the perspective of ECB is not a healthy policy. ECB in its attempt to bail out Greece uses expansionary monetary policy. That is, open market purchases that leads to increased money supply in the economy. An increase in the money supply increases the demand for securities such as bonds that raises their prices (Choudhry 2010; Brentani 2004). Bond prices and interest rates have an inverse relationship thus interest rates in the country fall. A fall in the interest stimulates investment leading to increased output. An increase in output increases the disposable income in the hands of the population that has an effect of increasing their aggregate demand for goods and services. Consequently, prices of goods and services go up from their increased demand that could be inflationary. On the other hand, a fall in interest rate stimulates capital outflows. Investors transfer their capital assets to other countries with higher interest rates where they can earn higher returns for their capital assets (Park 2008; Schneider 2003). Therefore, bail out of Greece is not a healthy process since it leads to increased prices of goods, services, and huge capital outflows that could worsen the economy. Why a group of economist thinks that a common currency like Euro for the region is not a good idea Despite the fact that a common currency has its advantages, it also has a fair share of its disadvantages. A common currency refers to events that a group of countries integrates their currencies to come up with one currency to be used across the region e.g. the Euro. The introduction of a single currency could result in an economic shock. A country with its own currency can adjust interest rates through monetary and fiscal policies either to encourage or discourage investment and consumer spending. A common currency like the Euro makes it impossible for a member country to adjust its interest, which could worsen its economy. A common currency also denies a member country the freedom to adjust its exchange rate in case of deterioration of its economy. A devaluation of currency would increase the net exports of a country since countries perceive it cheaper trading with a given country (Hollander 2011). Consequently, improvement in net exports causes economic stabilization. However, with a common currency, a country experiencing economic problems cannot readjust the exchange rate to improve its economy. Another negative effect of a common currency is that it denies a member country the freedom to adjust government spending during economic downturn (Rajan 2001). A common currency like the Euro has a Stability and Growth Regulation, which requires countries to maintain their budgets within the stipulated amount. Therefore, it denies a member country freedom to adjust its government spending to avert a recession in its economy. In summary, a common currency like the Euro is not a good idea since it could worsen the economies of member countries due to the stringent aspects of the common currency that makes it hard for member countries to readjust their economies. Assessment 2: 1. China has a fixed exchange rate with the dollar. The Chinese Yuan is undervalued compared to United States dollar, thereby causing a trade deficit. A trade deficit is whereby imports exceed exports. The United States view goods from China as cheaper, and thus, imports more. On the other hand, China is not in a position to import excess goods from the United States since the dollar has a higher value than their Yuan, thereby making it expensive to import goods from their counterparts. China is dismayed by the United States’ unconventional move of quantitative easing since it will increase the value of the dollar at the expense of Chinese Yuan. Quantitative easing denotes the move by the Federal Bank to purchase financial assets from financial institutions in an attempt to improve the economy. It is used where other monetary policies have failed. Undervalued Chinese Yuan Dollars per SYUAN Yuan Increase in China’s 0.20 export’s to US 0.12 DYUAN 200 700 1,000 Billions of Yuan Per Year 1. Let us assume the following information for an economy. C=10000+0.6Y I=2000 G=5000 X=600 M=400 [All the notations are standard as discussed in the class] a. The size of the multiplier in this economy Multiplier = 1 1 – b = 1 = 2.5 1 – 0.6 b. The short run equilibrium output Y = AE; C + I + G + NX AE = 10,000 + 0.6Y + 2,000 + 5,000 + (600-400) Y = 17,000 + 0.6Y + 200 Y = 17,200 + 0.6Y Y  0.6Y = 17,200 0.4Y = 17,200 Y = 43,000 News issued in Bloomberg a. Why do you think that there is going to be capital outflow? Thailand has a fixed exchange rate whereby the exchange rate is controlled by the government through the Bank of Thailand. The exchange rate is above the equilibrium thus, there is an excess supply of Thailand’s baht and a decrease in its demand. Consequently, Thailand’s baht excess supply leads to its devaluation. That is, a decrease in its value compared to other competing currencies such as the dollar. Devaluation in a country’s currency leads to interest rates falling causing capital outflows. Investors transfer their capital assets to other countries with higher interest rates in an attempt to maximize returns on those capital assets. b. the policy to be taken up by Bank of Thailand to avoid a free fall of their exchange rate and how they can achieve it The Bank of Thailand should buy its own currency with foreign currency from the reserves that serves to decrease supply of domestic currency in the economy and increase supply of foreign currency. Consequently, Thailand will experience a revaluation in its currency due to its shortage and increased demand compared to other currencies. The bank should apply contractionary monetary policy in order to curb increased money supply in the economy. It should conduct open market sales whereby it sells government bonds to members of the public thereby decreasing the amount of money in circulation in the economy. A decrease in the supply of baht in the economy will lead to increase in its demand. Consequently, Thailand will experience an appreciation in the exchange rate of its currency from the perceived shortage and its increased demand compared to other currencies. References Brentani, C 2004, Portfolio Management in Practice, Burlington, MA, Oxford [England Choudhry, M 2010, Capital Market Instruments: Analysis and Valuation, Palgrave Macmillan, Houndmills, Basingstoke Duggan, M & Scott, M 2004, The Distortionary Effects of Government Procurement: Evidence from Medicaid Prescription Drug Purchasing, National Bureau of Economic Research, Cambridge, Mass Hollander, B 2011, How Currency Devaluation Works, Rosen Pub., New York Krugman, P & Obstfeld, M 2000, International Economics: Theory and Policy, Addison-Wesley, Reading Mass: Megginson, W & Smart, S 2001, Introduction to Corporate Finance, Cengage Learning. Palmatier, G & Crum, C 2003, Enterprise Sales and Operations Planning: Synchronizing Demand, Supply and Resources for Peak Performance, J. Ross Publication, Boca Raton, Fla Park, D 2008, Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia, Asian Development Bank, Manila Qi, E, Shen, J & Dou, R 2013, The 19th International Conference on Industrial Engineering and Engineering Management: Assistive Technology of Industrial Engineering, Springer, Berlin Rajan, R 2001, (ir)relevance of Currency-Crisis Theory to the Devaluation and Collapse of the Thai Baht, International Economics Section, Princeton, NJ Schneider, B 2003, Resident Capital Outflows: Capital Flight or Normal Flows? A Statistical Interpretation, Overseas Development Institute, London Wiseman, L 2013, The Multiplier Effect: Tapping the Genius Inside Our Schools, Corwin, Thousand Oaks, CA Read More