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Euro Zone’s Divergent Economies and Monetary Policy

I got this image from The Economist and used it for a recent A2 Test on Macro-Economic conflicts. Recently the OECD and the IMF have urged the European Central Bank (ECB) to cut the bank’s main lending rate from the already low 0.25% to zero. How might this effect countries in the Euro-area? It will tend to impact euro zone countries differently because of where they are in the business cycle. If you look at the unemployment and inflation figures from the graph you see the following:

Unemployment
Austria 4.9%, Germany 5.1%, well below the EU average of 11.8%.
Spain 25.3% and Greece 26.7% very high unemployment.

Some countries have had unemployment dropped significantly during the period –
Latvia approx. 22% to 11.6
Estonia approx.. 18% to 7.8%

Inflation
Highest rate Malta &Austria 1.4%, Finland 1.3%
Lowest – Greece -1.5%, Cyprus -0.9%

Euro divergent economies

The loss of monetary sovereignty has its problems

Reducing the interest to zero is an expansionary monetary policy which is a tool to increase aggregate demand, economic growth and employment. Monetary Policy, which is determined by the ECB, will have different effects in different countries. The ECB responds to aggregate levels of inflation and unemployment, not individual country levels – Unemployment is 11.8% and Inflation is 0.5%. Therefore it is a one size fits all policy. However some member states maybe experiencing rising levels of inflation and lower levels of unemployment whilst others might be the opposite – falling levels of inflation and higher levels of unemployment.

Assume an EU member experiences an asymmetric shock. It will have a different inflation and unemployment rate than the rest of the EU. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their monetary policy. This is a major problem if a countries economy is at a different stage in the business cycle. For instance in 2014, Austria and Germany are growing with falling unemployment and a further lowering of interest rates may not be the best option for them. This is in comparison to other countries who need lower interest rates and a more stimulatory environment. With low interest rates and falling unemployment, Austria and Germany could experience inflation levels above the 2% target of the ECB and also a tight labour market which could put pressure on prices. Furthermore a lower interest rate affects those who want to save money in those countries.

At the other end of the spectrum Slovakia, Portugal, Cyprus, Spain and Greece are experiencing deflation and very high levels of unemployment. They therefore require more stimulus through lower interest rates to try and boost growth and employment and get out of the dangerous deflationary cycle.

Other countries with low inflation and high levels of unemployment will benefit from the cut in interest rates – Ireland has had unemployment fall from approx. 15% to 11.8% and an inflation rate of 0.3%. Therefore monetary stimulus is warranted. However the interest rate whether expansionary, neutral, or contractionary is unique to where each country is in the business cycle. The loss of monetary sovereignty clearly poses problems for members states whose economy is out of line with the euro zone norm.

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