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Q1. What are the arguments in favour of free trade and in favour of protectionism? 2
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Q2. What are in theory transmission mechanisms of monetary policy? 4
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By controlling the supply of money, availability of money, and cost of money (interest rate):
It affects the following factors:
Financial asset prices
By increasing money supply, the cost of money (interest rate) will decrease and as a result financial asset prices will increase.
Consumption
By increasing money supply, the availability of money increases and as a result consumption will grow (aggregate demand will increase).
Investment
By increasing money supply, the cost of money (interest rate) will decrease and we will have access to cheaper money to invest, therefore investment increases.
Current account equilibrium
By increasing money supply, the cost of money (interest rate) will decrease and exchange rate will decrease therefore we have more motivation to engage in foreign exchange and as a result export grows and imports decreases.
Expectations
By increasing money supply, the cost of money (interest rate) will decrease and it will shape expectations towards inflation (inflation will be expected) and as a result we will have increase in inflation. 5
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Q3. Analyze FED and ECB monetary policy with figure 1. 6
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To analyze, we classify time periods shown in the figure into two parts for each bank:
Positive slope or Incremental periods (periods when the interest rate has been increasing):
FED
Jan 1999 to May 2002 – approx. 1.8% increase
May 2004 to May 2006 – approx. 4.2% increase
ECB
Jan 2000 to Sep 2000 – approx. 2.3% increase
Jan 2006 to May 2007 – approx 2% increase
Analysis:
ECB behavior has followed FED behavior with a time lag. This implies that ECB economy is very dependent on FED economy.
Despite the fact that ECB increase rate has been higher in the first period of increase, the FED increase rate has been higher in the second period of increase. As we know, increase in the interest rate means reduction in money supply. Therefore we can deduce that in the first increase period, ECB has had a stronger reduction in money supply, while in the second increase period, the FED has adopted a stronger money supply reduction.
Negative slope or decremental periods (periods when the interest rate has been decreasing):
FED
Jan 2001 to May 2003 – approx 5.5% decrease
Sep 2007 to Jan 2009 – approx 5.2% decrease
ECB
May 2001 to May 2003 – approx 2.8% decrease
May 2008 to May 2009 – approx 3.2% decrease
Analysis:
We can see that ECB behavior has again followed FED only with a time lag. This confirms that ECB economy is highly dependent on FED economy. This seems to be due to the fact that ECB is a young institution and its current problems with credibility, heterogeneity and independence (in comparison with FED).
In both periods of decrease, the decrease rate of FED has been higher than ECB’s decrease rate. This implies that the FED has had a stronger money supply increase. 7
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Q4. How to reduce sovereign debt to GDP ratio? 8
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To reduce this ratio, we must either increase GDP or decrease sovereign debt.
It is hardly possible to increase GDP by fiscal policy decisions in short term, but in long
term, increasing investment, increasing taxation, increasing balance of payments (more
exports than imports) can result in increase of GDP. However in short term, the answer
to the question lies in reducing sovereign debts.
According to this formula: Gt + i.Bt-1 = Tt + (Bt - B t-1) and the modified version:
Bt = Gt - Tt + (1 + i)Bt-1
Note that :
Bt is public debt during period t
Gt is government spending
Tt is government revenue
i is normal interest rate of public debt
In order to minimize Bt (public debt) we have the following choices:
Minimizing Gt or government spending. This can be done by fiscal policy (budget adjustments).
Maximizing Tt or government revenue. This can be done by increasing taxes.
Minimizing i or interest rate of public debt. This can be done by monetary policy (increasing money supply – i.e. inflation) 9