Read the assigned pages from Chapter 8, Economics of Monetary Union, by Paul De Grauwe, and answer the following questions.
1-(12 Points)
a-Was the European Central Bank modeled after the French Central Bank, the British Central Bank, or the German Central Bank?
From the study of the article, by Paul De Grauwe, we learn that at the time the design of the European Central bank, there were two prime choices; Anglo-French Model and, in which Price Stability is one of the primary objectives, and German Model, in which Price Stability and political independence are the primary concerns. After great liberation and discourse, it was decided that the design of the European Central Bank, would be similar to German Model. It suggests that the European Central Bank is politically independent and intends to stabilize the economic system by regulating prices or controlling inflation. It also suggests that monetary policy, which is adopted by European Central Bank, is independent and it can expand and contract the money supply at will by keeping in consideration needs and requirements of the European Economy.
b-Does the European Central Bank care more for price stability or a high level of employment? Explain your answer.
Typical or Anglo-French Modeled Central banks are more concerned about employment as it is a prime concern of state and to pursue it uses various kinds of strategies and tools. For instance, the Federal Reserve Bank uses various strategies, such as expansionary and contractionary monetary policies and instruments, such as open market operations, to meet the mentioned objectives. However, the European Central Bank is very conservative and it keeps its focus to the price-stability is primarily because it is based on the German central bank. For this particular reason, the European Central Bank changes use different kinds of tools at its disposal with the objective to stabilize prices, rather than to achieve particular employment and output objectives.
c-Which Central Bank reacts more strongly to a recession, the European Central Bank, or the Federal Reserve System?
Recessions are that period in the business cycle, when consumption dwindles, which decreases prices, output, investment, and employment. Therefore, it is natural that central banks around the world take measures to mitigate the ramifications of the recession. Also, they also work to ensure that the recession may not turn into a depression, which is a more severe economic catastrophe. Evidence suggests that during the recession, it was the Federal Reserve that played a more active role, as it more frequently fluctuated interest rates and performed open market operations with the objectives to meet various objectives, which included 1) inflation, investment, and high employment. In contrast, during the same period, the role of the European Central bank was highly conservative and remained confined to the stability of prices.
2-(8 Points) Paul De Grauwe writes “The Treaty recognizes that political independence is a necessary condition for ensuring price stability.” Explain this statement.
Central banks, which are based on the Anglo-French model, are not as politically independent as central banks that modeled on the German Central bank system. It is because Anglo-French modeled central banks have multiple objectives, which include meeting employment and output targets. For that reason, the government can influence interest rates and ask central banks to print currency notes. However, European Central Bank’s prime objective is price stability, for which political independence is imperative. Therefore, to ensure that prices remain stable, it was made sure that the European Central bank is free of political pressure. Political pressure may create complications for the European Union.
3-(8 Points) According to the author, does the European Central Bank have “enough accountability”? Explain your answer.
With authority comes the responsibility and accountability. The democratic systems are based on the concept of power and accountability. It is also true for Central banks, no matter what their structure is or on what model they are based. From the study, we learn that there are internal and external accountability systems. The Internal accountability system includes intra-organizational institutions and results, whereas external accountability system refers to parliament, Congress and Senate. The Federal Reserve Bank, which is an American central bank, is accountable to various committees of the senate and congress. However, evidence suggests that the Central Bank is not as accountable as other banks, which suggests that its performance is an affected one as accountability pushes an institution to perform optimally.
4-(12 Points)
a-What did the European Central Bank do to help the economies of its members recover from the financial crisis of 2007-2008?
The Great Recession, which was the result of the sub-prime mortgage crisis, put the world banking system under tremendous pressure. The European Banking system also got adversely affected because of the collapse of Lehman Brothers, of which the European banks have bought insurance. It created a severe liquidity crisis, which evolved into an existential threat to the European banking system. At this critical juncture, European Central bank appeared as a last resort and bought bonds in the secondary market. This massive liquidity injection averted the impending collapse of European banking system.
b-Paul De Grauwe wrote: “It looks like the carrot provided by the ECB will be accompanied by a big stick.” What did he mean by this statement?
The mitigate the ramifications of the Great Recession, European Central bank bought bonds, which would mature in three years, in the secondary market. This Outright Money Transaction addressed the liquidity concern of many affected economies, such as Spain and Portugal. It provided them much needed cash for the various banking activities. However, these carrots come with the stick of austerity, which focuses on cuts in government expenditure and reliance on monetary policy to meet the objectives. It also compels economies to maintain a particular price level, which does not allow them to experiment with the interest rates. Evidence suggests that it has a complicated economic situation in particular countries.
Read the assigned pages from Chapter 5, Economics of Monetary Union, by Paul De Grauwe, and answer the following questions.
5-(10 Points) According to De Grauwe, what events led to the “crash” of 2008 in Greece? Explain.
In fact, the article suggests that economic challenges, for Greece, started to appear, in severe form, in 2010. When the economies around the world were facing severe recession, Greece’s economy was expanding at an exceptional rate. In fact, the real GDP growth had reduced the unemployment from 12% to 8%; however, during this period of boom, the government continued to use the monetary instrument, which increased the debt from 94% to 103%. It must be recognized that during the boom, fiscal expenditure drops significantly, which allows budget deficits to decrease. However, from 2000 to 2010 the private debt increased dramatically, and in the year 2010, it tripled from what it was in 2000. During this same period, the cost of labor, per unit, increased almost 20%, which also increased the cost of production and eventually the prices of items and commodities, which is the concern of the European Central Bank. Also, Greece’s government switched out the automatic stabilizers.
6-(10 Points) Were the costs of adjusting to the financial crisis of 2008, higher for Greece than they were for other countries? Explain your answer.
It is quite apparent that Greece has to pay the higher price of financial adjustments, which are imposed by the Great Recession, of 2007. It is because Greece economy is one of the largest economies in the world and because of imprudent steps it took during the boom period, it created various challenges of intense nature, For instance, the increase in the debt and the cost of production affected government’s/central bank’s ability to perform and reduced competitiveness of industrial and service sectors of the economy. Also, because the Greece bondholders were selling these bonds rapidly, the interest rates increased, which reduced investment, as already cost of production was high because of high labor cost.
The economic rescue required European Central Bank monetary assistance, which comes with the condition. For instance, European Central bank offered assistance on the condition of strict austerity conditions. It gave less freedom to the Greece’s government to use the monetary instrument, which was essential to move out this grave economic situation. In fact, because of the austerity policy, the situation became more complicated for the Greece economy.
7-(8 Points) According to De Grauwe, is Greece likely to leave the Eurosystem? Why or why not?
Grexist has both pros and cons for both Greece and the European Union. One of the major concerns is that if Greece leaves the European Union or it is kicked out, there is a likely hood that the entire banking system would come under threat as Greece will default on its debt. However, this default on its debt will devalue its currency, which will allow the economy to expedite economic progress and increase the level of employment in the economy. However, this also causes inflation, which will be another concern for the economy. Also, any existence of the Greece from the European Union will be temporary, as per author. However, the chances of such exist are slim, which suggests that this terrible marriage will continue for years.
Read the assigned pages from “Has Financial Development Made the World Riskier?”, by Raghuram G. Rajan and answer the following questions.
8-(11 Points)
a-According to the author, what were the three developments that changed our financial system? Explain.
The article focuses on three instrumental changes, which have evolved or altered the financial system and played a part in its globalization. These changes are 1) Technical Changes, 2) Deregulation and 3) Institutional Change. Technical Change has reduced the cost of communication, and it has enabled to store and use information more systematically and precisely, as per requirements. Deregulation is mitigated and in some cases eradicated artificial barriers, which not only prevented entry, but also aided in the established of monopolistic competition. It also increased competition between markets, products, and institutions, impacting jurisdiction factor at the same time. The institutional changes, on the other hand, have created new entities, such hedge funds, and equity firms. These changes are impacting forces, which yielded contemporary financial system.
b–Did the author think that the changes in financial markets would make the fluctuations of the business cycle larger or smaller?
The author subtly suggests that the contemporary financial system has adversely impacted the overall economic system. It is because the contemporary financial system can impact employment and investment in large scale. This altered financial system is highly sensitive to incentives, which are produced by an economic system and it has developed tools to exploit these incentives or financial/economic opportunities. It also suggests that because of these new abilities, it can influence and impact the economic system. It is what we have witnessed, during the 2007 economic recession, during which financial sector played a significant part (subprime mortgage crisis). We also learn that the financial sector can intensify economic contradictions, by imprudent measures.
9-(6 Points) Raghuram Rajan wrote:“the expansion in the variety of intermediaries and transactions has major benefits.” What are these benefits?
This paper suggests various kinds of benefits of the expansion in the variety of intermediaries and transactions, which have been discussed in great detail in this paper. The mentioned benefits are 1) reduction in transaction costs of investing, 2) expanding access to capital, 3) allowing more diverse options to be expressed in the marketplace and 4) allowing better risk management options. All these benefits allow firms, which to operate more independently in the financial sector of the economy.
10-(10 Points) According to the author, our “new” financial environment has a problem with “incentives.” Explain this problem.
The contemporary financial system has facilitated financial firms that operate in the financial sector of the economy to develop abilities to exploit various kinds of incentives. Also, these financial institutions and firms are incentive or profit-oriented; therefore, they aggressively pursuit incentives. Furthermore, the financial sector can produce opportunities on its own, which is a controversial feature. The prime example of such failure is subprime mortgage crisis, in which private lending industry played a significant part. Also, it also increases imprudent and adverse consumption and investment in particular sectors of the economy, such as real estate or housing industry. We also learn that managers have incentives to aggressively pursuit profit, as it has higher monetary rewards and the consequences of it do not affect them.
11-(5 Points) The author suggests a solution to the problem of incentives. He calls it “alignment of incentives.” What does he mean?
The managers are responsible for implementing strategies and them responsible for pursuing financial objectives. The higher the profit they generate, for the financial firms, more the reward. However, this pushes them to take imprudent decisions, which benefit only in the short run. Another reason for these imprudent decisions is that managers do not have stakes in the firm. When a portion of the capital asset, of the manager, is an investment in the firm, he/she tends to act more responsibly. It is called alignment of invectives by the author.
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