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Economics i

Assessment 1

Course Information

Professor Information

Question 1

  1. Impact on interest rate of ECB bailout plan

Following the bailout by European Central Bank, it was expected that interest rate in Greece would decline. The bailout plan involved the transfer of deposits from the European Central Bank to banks and other financial institutions in Greece. The step taken by central bank affects money supply and interest rate as explained using the money market diagram in figure 1.

Figure 1: interest rate and money supply.

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Interest rate

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The money market is such that demand for money is inversely related to interest rate. When interest rate moves down due to an incremental money supply, a lower equilibrium is attained at point
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  1. Impact of ECB policy on output and prices

In a research by Tragakes (2011), a change in interest rate caused by changes in money supply affects two components of aggregate demand namely investment and consumption. Since part of consumer spending is paid through borrowing, the decline in interest rate would increase the level of consumption spending. In the same manner, investors would borrow more money for their investment needs. Cognizant of the fact that
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, r=10%1AE

, r=6%2AE

Figure 2: Impact of bailout on aggregate expenditure and the AD-AS model

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Aggregate Expenditure

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If the economy were initially at equilibrium Y1, a reduction in interest rate, say from 10% to 6%, would shift aggregate expenditure curve from AE1 to AE2. This increase in expenditure is also shown by a shift in aggregate demand from AD1 to AD2 with the effect of increasing real GDP to its potential level. However, the rightward shift in AD is accompanied by higher prices as shown in figure 2 above.

  1. Impact of expansionary fiscal policy on the prices

The expansionary fiscal policy increases money supply. In response, consumer spending as well as investment expenditure will increase consequently shifting AD curve to the right as shown in figure 3 below.

Figure 3: Rightwards shift in aggregate demand due to expansionary fiscal policy

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From figure 3 above, the expansionary fiscal policy has the effect of shifting AD curve to the right from AD0 to AD1 resulting in higher output and price. It is visible from the diagram that output increased from Q0 to Q1 while the price rose from P1 to P2. The expectation that price will increase motivates workers to demand for a higher wage. This causes the cost of wage to increase leading to a leftward shift in AS curve. In the long run, the economy will settle at a higher price level, inflationary consequences.

  1. Perspective of ECB on Greece bail out

From the perspective of ECB, the bailout of Greece has its advantages and disadvantage. The ECB holds a view that the bailout will develop confidence in member states that a rescue is available whenever there is a problem in financial sector. As a result, there will be reckless spending by member states. Secondly, the bailout plan could expose ECB to political meddling where ECB will be viewed as the first resort in case of a fiscal distress. Furthermore, ECB holds a view that the bailout plan has inflationary consequence especially when dealing with level of a large country.

Notwithstanding the aforementioned negative impact of the bailout, ECB maintains that the bailout helps to reduce contagion effect. Besides, the provision of liquidity helps the improve demand in the affected economy.

  1. Common currency is not a good idea

The renunciation of individual monetary policy is not sustainable given the asymmetrical shocks that affect different countries in different ways. It is important to note that a country operating its own monetary policy is best suited to respond to economic crisis such as unemployment. When unemployment is high in the country, the nation can utilize its own monetary policy to lower interest rate in order make it easier for people to borrow money for investment purposes, which eventually improves employment. However, when a country is part of a common currency such as Euro, the European Central Bank has the discretion to lower the interest rate or not. If the European Central Bank decides not to respond, then the country will suffer from high unemployment. There is no doubt that under a common currency, a member state lacks an efficient instrument to respond to economic challenges peculiar to the country.

Reference List

Tragakes, E. (2011). Economics for the IB Diploma with CD-ROM. Cambridge: Cambridge University Press.