The ways in which membership of the euro area constrains national economic policy

There are currently 17 members of the euro area - all of whom are also in the EU. It is obligatory that members of the EU be in the eurozone, however they do have to meet certain requirements. There are 10 EU member states that do not use the euro as their sole currency, of these 10, 7 have yet to meet the requirements and will join when they meet them, and the other 3 (including the UK) have opted out.

There are reasons for these opt-outs, as membership of the euro area does constrain national economic policy in a number of ways. The first and most obvious way is the loss of control over monetary policy once you join a monetary union (such as the eurozone). Monetary policy in the euro area is conducted by the European Central Bank (ECB), which is located in Frankfurt. The ECB controls the base interest rate for the euro, and also holds reserves which it can use to bail out failing members of the eurozone if necessary to help the economic well-being of the other members. The governments of the individual countries don't miss out on anything, as the interest rates for their currencies (if they didn't use the euro) would probably be controlled by a central bank anyway. The problem, then, lies with the difficulty the ECB has in setting an interest rate that is suitable for all of the members of the euro area. There are 17 different members, with different economic and social structures, which can lead to a lack of convergence in their economic cycles (as discussed in the case study). Simplified, the lack of convergence means that while one country may be experiencing a period of economic boom, another country in the euro area may be in a recession. The "booming" country may want high interest rates in order to control the price level, while the country in recession would want exactly the opposite. This delicate balancing act is very difficult and is often criticised.

Also, as I have mentioned in previous posts, the euro area operates with a non-symmetrical inflation target which means that there is not the same emphasis put on increasing the inflation rate if it is too low, as there is on reducing it when it is too high. In my opinion this is a flaw in the system of the euro area, as it tends to lead to higher-than-necessary interest rates which does indeed lead to low price leves, but often at the cost of low economic growth and high unemployment.

Furthermore, certain signals that should be given off by changes in the exchange rate are often dampened in a monetary union the size of the euro area; one country's economic performance does little to affect the overall exchange rate of the euro. Ireland complained following their deep recession that, if they had their own currency, their large increases in AD would have led to high levels of appreciation of that currency and could have slowed down the level of export-led growth (as long as the demand for their exports was price elastic) and possibly helped give some early-warning signs to the government that a recession was on the horizon.

The concept of "Purchasing Power Parity"

Purchasing Power Parity (PPP) is a theory of long-term equilibrium exchange rates based on the relative price levels in two countries. In other words, it shows the difference in actual value of a currency in terms of what you can buy with it. PPP is measured by taking the price of a basket of goods in one country and comparing it with the price of the same basket in another country.

It would be assumed that the nominal exchange rate and PPP would be relatively similar. However, we can normally see a marked difference in PPP-adjusted exchange rates compared to nominal rates. India, for example, has a GDP per capita of $1,100 if we are using the nominal exchange rate, however when the figures are PPP adjusted, the GDP per capita is closer to $3,000.

PPP figures are based on the "law of one price" which assumes that something costs the same amount wherever you go. If we take a Big Mac in France and a Big Mac in England, it is assumed that relatively they should cost the same amount, and then we can compare them directly to get PPP adjusted exchange rates between England and France. If Big Macs are just genuinely cheaper in France, this can skew the results as it means the law of one price does not apply. It has been said, however, that because PPP measures are made using a large "basket" of goods, that even where the law of one price does not apply, the results shouldn't be affected too much and this is normally not a worry.

A further problem to measuring PPP is the fact that some products are simply not available in certain countries, and they therefore cannot be used for comparison. Therefore as a general rule, countries with similar economic structures and similar trends of consumption tend to have more accurate PPP-adjusted exchange rate figures. Similarly, in some (mainly poor or developing) countries any statistics can be rather difficult to attain as the government records are not necessarily sound.

Explain the concept of a "Soft Currency"

A hard (or strong) currency is one that can be used to trade internationally and that is a stable store of value. Hard currencies are normally present in politically and economically strong countries, with stable government and low inflation. It is expected that hard currencies will not depreciate in value against other currencies, as this would be a characteristic of soft currency.

Soft currencies, conversely, are the opposite of hard currencies. A soft currency is expected to de-value compared to over time and is normally the currency of developing countries such as Zimbabwe. The Zimbabwean dollar was a good example of a soft currency, as their inflation rates were as high as 3714% per year, which was in part due to, and in part led to the printing of money. Currencies such as the Zimbabwean dollar are rarely used for international trade or for keeping large stores of.

There were fears at first that the euro would be a soft currency, but such fears were not realised and this is probably no surprise - given the nature of the economies who use it as well as the highly specific entry requirements. There also seems to be quite effective management of the currency by the European Central Bank. Their interest rates are higher than those set by the central bank in the UK, and eurozone growth is higher than that in the UK, which puts the EU in a better position than ourselves. Also, the ECB clearly doesn't want any countries to drag the currency down, such as Portugal, as they are choosing instead to take very drastic measures such as bailouts as well as setting strict fiscal policy guidelines to those countries that fail to manage their own economies successfully.

Assess the extent to which a rise in imports may affect macroeconomic performance

Analysis    (how it will be detrimental to macroeconomic performance)

-Short run: C+I+G+(X-M). An increase in M will reduce AD. (diagram)

-It’s a leakage from the circular flow

-Could increase unemployment as domestically produced goods are replaced by cheaper imported substitutes

-Means our BoP is worse

Evaluation (how it may help performance)

-Could lead to lower prices and increased variety of goods (as long as it’s not just the price that has increased

-May reduce inflation

-If it’s combined with a subsequent rise in exports, then we could reap all the rewards as well as not losing out on AD

-May kill off inefficient industries that shouldn’t have existed

-Could be due to a time of economic boom which in itself is good

The role of the IMF

The International Monetary Fund (IMF) is the organisation that oversees the macroeconomic policy of all of its members (most of the world), it particularly focusses on policy that affects exchange rates or the balance of payments; because its goals include stabilisation of international exchange rates as well as trying to facilitate growth and development. Members pay a certain amount that goes into a pool which is then used to bail out failing members - a sort of "insurance" system.

The IMF conducts its work by publishing reports on its members. One of these reports was published in 2009 on the Spanish economy and mentioned that Spain needed to introduce policies to improve its international competitiveness, as their wage and unit-labour costs were outpacing the other countries in the euro area.

The difficulties of reducing large public sector deficits such as those in Ireland, Italy and Greece

The EU says that its members can have a deficit of no more than 3% of GDP per year, and that total government  debt should not exceed 60% of GDP. These are seen now as more of guidelines than actual rules, as most of the member states have broken one or both of them (including Germany).

Currently, Italy, Ireland and Greece are running huge public sector deficits, due to their generous welfare systems along with highly-paid public sectors - not to mention the tax evasion that is rife in Greece - which are having to be financed by large amounts of borrowing, subsequently increasing total government debt. Because the EU sets out guidelines of the amount of borrowing that is acceptable, once an economy begins to exceed these, they are warned that if they cannot control their borrowing through either increases in taxation or reductions in public spending (austerity measures) then the central bank will take control of their fiscal policy and make the cuts for them, as well as potentially bailing them out. This happened in Portugal, where they were dangerously close to "defaulting" which is effectively a declaration of bankruptcy and saying that you are unable to repay your loans. Defaulting is best avoided.

While raising taxation and/or cutting public spending sounds like a relatively straightforward way of reducing the deficit, it is not. It is very difficult to increase taxation or reduce government spending without harming economic growth, and just after a global recession, this can be disastrous, as it could lead to a double-dip recession. Cutting government spending would harm economic growth in the short run as government spending is a component of AD, it would also affect long run potential growth as it may lead to schools having to close or public sector jobs being lost. Increasing taxation would also harm growth by reducing levels of investment by firms or reducing consumption as people have less disposable income (income after tax), both of these are also components of AD. In Spain, as it says in extract 3, they "feared the social consequences of high unemployment" which may be brought about through public sector cuts, this led to them increasing unemployment benefits which puts a further strain on the government budget.

Furthermore, if a government chooses to continue with high levels of public expenditure in order to grow out of the recession before deciding to make cuts, they may risk losing their credit rating, currently the UK has a AAA credit rating, and because the government is doing lots to reduce our deficit, it seems that we will keep it. Spain, however, recently had its rating reduced for the banking sector to AA. The effect of a lower credit rating means that you are considered less likely to re-pay the debt you owe, which means lenders will most probably increase the interest rates they ask for in order to outweigh the risk of lending.

In conclusion, it is the risk to economic growth, as well as the social consequences that make reducing large deficits very difficult. It is, however, necessary if a country wishes to continue to be able to borrow at low interest rates in the future.

An explanation of the functions of the European Central Bank.

The European Central bank (ECB) was started in 1998 and, like all central banks, exists to control monetary policy over a given area, in this case, the Eurozone.

The ECB's main function is to keep the price level down. The inflation target for the Eurozone is 2%, and the current rate of inflation in the euro area is 2.7% (March 2011). This suggests that the price level is too high, and trends have shown that it is only increasing. This means that the ECB is expected to use its control over monetary policy to stem this rising interest rate, which it is clearly doing, as on the 7th of April the ECB announced that it would increase euro-area interest rates to 1.25% from 1%.

As well as controlling interest rates, another part of monetary policy is the amount of money printed and injected into the economy as quantitative easing. This can be used to boost AD, but can come at the cost of high levels of inflation, as it involves increasing the supply of money, which will reduce its value.

It has been said, and can be found in the introduction of the stimulus that low base interest rates set by the ECB coupled with high inflation rates in Ireland, Spain and Greece led to negative real interest rates, which put huge amounts of pressure on the banking sector and resulted in very high levels of borrowing and low levels of saving (as money was de-valuing). This is an example of one of the difficulties faced by the ECB, as it has to try and set one set of monetary policies that appeals to everyone. Critics of the system may say that it shouldn't be difficult, as by now the economic cycles of the Eurozone countries should have converged, but clearly they have not, and, as the stimulus mentions, there is risk of a "two-speed" euro area developing.

The extent to which free trade will be beneficial Europe

The EU is a monetary union, not a free-trade area, like NAFTA, however there is free trade in the EU.

Free trade seeks to utilize the theory of comparative advantage to achieve mutual benefit from those involved. The theory of comparative advantage says that through specialisation and trade, countries can produce outside their productive capacity and PPC (production possibility curve) and produce up to their TPC (trading possibility curve). Theoretically, then, where there is comparative advantage, there is a potential for mutual benefit from trading. The theory of comparative advantage doesn't, however, take into account transport costs or any trade barriers such as tariffs, so in order to fully benefit from comparative advantage, there needs to be a free trade agreement such as the one in the EU, which suggests that the EU benefits from these advantages.

There are, however, drawbacks. Firstly, the initiation of a free trade agreement, while it will create new trade partners (trade creation), can harm trade with countries outside the free trade area (trade diversion). Secondly, international trade leads to higher levels of competition in the market, and can therefore "kill off" under-performing industries, as well as infant industries. This could have been part of the problem for Spain in 2009, as some of their industries may have been functioning well at a domestic level, but after the increased competition entered from overseas, such industries could no longer remain competitive and were forced to close. This would lead to higher reliance on imports for the Spanish economy, and could also lead to a long-term lack of competitiveness as infant industries that would grow and become competitive lose the help they would normally get from the government in the early stages of development.

A further problem of free trade in areas such as Europe is that if one economy enters a recession, it can affect the entire free trade area, especially if the share a currency such as the euro. This is because as soon as one country in the eurozone starts to underperform, foreign investors will lose confidence in the whole area and stop investing which would lead to a lack of FDI and limit AS. As this starts to happen, confidence within the trade area starts to decline and less products get traded as well as businesses losing confidence and not investing in development and research. Such confidence problems can quickly spread throughout economies that are so closely integrated. The quote on p11 of the stimulus from a speech by Pascal Lamy illustrates that "Internatonal trade was a casualty of the global recession and world trade shrank by 12% in 2009." Which supports my point.

To conlcude, while free trade is useful in increasing the productive capacity of all economies in the free trade area, it can be dangerous to integrate too closely with other economies as it is easy for one failing country to drag all of the others down.

What is "hot money" and why does it matter for the exchange rate?

Hot money is money invested in an economy by foreign investors. Unlike FDI, it is not a long-term investment, quite the opposite. Hot money is a short-term concept that revolves around speculation of interest rates and exchange rates.

We can see that flows of hot money affected the economies of Spain and Greece in 2009 as they had a period of negative real interest rates fuelled by a low base rate (set by the ECB) and high levels of inflation which led to a reduction in foreign investment as their money was de-valuing. This could have contributed to their economic decline.

Hot money tends to be invested by rich developed countries in poorer countries that have higher interest rates in order to capitalise on the increased returns from banks etc. Speculation is the key to determining the flows of hot money, and if interest rates are expected to rise, then more people will invest. This means that the flows are erratic and difficult to predict. This can affect the balance of payments by making it much more unstable, as economies can react badly to huge changes in capital flows. Sudden inflows of capital in the short term can lead to appreciation of the exchange rate which can, if persistent, lead to a lack of competitiveness of their exports.

Is GDP per capita the most appropriate measure of economic success?

GDP (Gross Domestic Product) is the sum of all the goods and services produced in an economy. GDP per capita is GDP/population. GDP per capita has been the accepted way of measuring economic success, but with the emergence of a number of other measures such as the HDI, the question is being raised: Is it the best measure of economic success?

GDP per capita is effective as it is a globally accepted measure that is relatively simple to measure and understand, it is a useful measure of wealth in an economy, and while higher average wages normally leads to higher levels of happiness and fewer problems such as lack of basic necessities, GDP per capita is not necessarily the best measure of economic success.

One problem with using GDP per capita to measure a country's economic well-being is that it is an average, and doesn't show income disparity. A more appropriate way of measuring equality is the Gini coefficient. For example, the USA has a high GDP per capita, $45,000, but its Gini coefficient is around .45 which means there is a very large amount of inequality.

The second flaw in the GDP per capita measure is that it doesn't take into account the informal economy. Because GDP is measured on tax revenue for the government, produce on which tax is not paid doesn't get factored in, but does still contribute to the wealth of the population. Mexico, for example, has a GDP per capita of only $8,000, but estimates of the informal economy suggest this figure could be around 50% larger.

Finally, GDP could be seen as a less credible measure of economic success as it does not measure the sustainability of the growth. It is a measure of economic activity, rather than a projection method, which means it could be due to unsustainable overuse of resources or poor allocation of investment.

While it is an easy and accurate economic measurement, GDP per capita is, in many cases, inappropriate for measuring economic success. Better methods would be a combinations of things such as the gini coefficient and the HDI as well as other measures of happiness among the population.

Causes of cyclical instability in an economy such as the UK

While economic growth in the long run may be a smooth curve that trends upwards, in the short-term there are large, regular fluctuations in growth. This is due to the economic cycle, which is the trend for economies to experience high levels of growth, then a slowdown followed by recession, and finally, a recovery.


Cyclical instability can occur due to shocks to either demand or supply.


Demand side shocks are unexpected events that influence the demand in the economy, they can be caused by other countries as the UK trades with countries from all over the world. They can be caused by:
  -Significant rise or fall in the exchange rates in the short term
  -Changes in the rate of economic growth with trading partners
  -Shifts in AD
  -A boom in capital expenditure


Supply side shocks affect the costs and prices of supply and changes may be due to
  -Technological changes
  -Natural disasters which may limit the supply of crops etc and therefore change their prices
  -Political situations that may affect the price of goods such as oil and gas. An example of this can be seen when Russia cut off the supply of gas to Ukraine for political reasons