Sample IB Economics Internal Assessment Commentary - Macro

Paul Krugman clearly explains the problems faced by two or Europes largest economies
today:

So why is Spain along with Italy, which has higher debt but smaller deficits in so much
trouble? The answer is that these countries are facing something very much like a bank run,
except that the run is on their governments rather than, or more accurately as well as, their
financial institutions.

Heres how such a run works: Investors, for whatever reason, fear that a country will default
on its debt. This makes them unwilling to buy the countrys bonds, or at least not unless
offered a very high interest rate. And the fact that the country must roll its debt over at high
interest rates worsens its fiscal prospects, making default more likely, so that the crisis of
confidence becomes a self-fulfilling prophecy. And as it does, it becomes a banking crisis as
well, since a countrys banks are normally heavily invested in government debt.

Now, a country with its own currency, like Britain, can short-circuit this process: if necessary,
the Bank of England can step in to buy government debt with newly created money. This
might lead to inflation (although even that is doubtful when the economy is depressed), but
inflation poses a much smaller threat to investors than outright default. Spain and Italy,
however, have adopted the euro and no longer have their own currencies. As a result, the
threat of a self-fulfilling crisis is very real and interest rates on Spanish and Italian debt
are more than twice the rate on British debt.

Commentary:
The European Central Bank (ECB) is engaging in a new form of monetary policy in which it
buys government bonds directly from the Spanish and Italian governments. Essentially, the
goal is to bring down the interest rates on Italian and Spanish government bonds, which
should reassure private investors that Italy and Spain will be able to pay them back and thus
reduce the upward pressure on interest rates in the Eurozone, a situation which threatens
to reverse the already sluggish recovery from the recessions of 2008 and 2009.

Monetary policy refers to a central banks manipulation of the money supply and interest
rates, aimed at either increasing interest rates (contractionary monetary policy) or reducing
interest rates (expansionary monetary policy). The ECB is currently buying government
bonds from European governments, effectively increasing the supply of money in Europe

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Sample IB Economics Internal Assessment Commentary - Macro

with the hope that more government and private sector spending will move the Eurozone
economy closer to its full employment level of output, at which workers, land and capital
resources are fully employed towards the production of goods and services.

If successful, the ECBs quantitative easing, as the new type of monetary policy is known,
should bring down interest rates on government bonds and thereby reallocate loanable
funds towards Italy and Spains public and private sectors. The increase in supply of
loanable funds should bring down the private interest rates available to borrows (businesses
and households), making private investment more attractive.

The ECBs bond purchases make it cheaper for Italy and Spain to borrow, lowering the
interest rates on their bonds, restoring confidence among international investors, who may
be more willing to save their money in Italy in Spain. The inflow of loanable funds into these
economies (seen as an increase in the supply of loanable funds from S1 to S2) should bring
down private borrowing costs (the real interest rate), encouraging more firms to invest in
capital and more households to finance the consumption of durable goods, increasing
aggregate demand and moving the Eurozone economy back towards its full employment
level of output, from AD1 to AD2 in the graph on the right.

In certain circumstances, monetary easing like this could be inflationary, but in reality
inflation is unlikely to occur given the large output gap in Europe at present (represented
above as the distance between Y1 and the dotted line, signifying the full employment level

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Sample IB Economics Internal Assessment Commentary - Macro

of output). Any increase in aggregate demand will lead to economic growth (an increase in
output), but little or no inflation due to the excess capacity of unemployed labor, land and
capital resources in the European economy today.

With private sector borrowing costs increasing due to growing uncertainty over their deficits
and debts, the Italian and Spanish governments will find expansionary fiscal policies (tax
cuts and increased government expenditures) are unrealistic options for achieving the goal
of full employment. The ECB, however, as Krugman argues, should continue to play an
increasing role in the expansion of credit to cash strapped European governments, with the
aim of keeping interest rates low to prevent the crowding-out of private spending that often
occurs in the face of large budget deficits. Inflation, always a concern for central bankers,
should be a low priority in Europes current recessionary environment. Only when consumer
and investor confidence is restored, a condition that requires low borrowing costs, will
private sector spending resume and the Euro economies can begin creating jobs and
increasing their output again.

In the short-term, Italy and Spain should take advantage of the ECBs bond-buying initiative,
and make meaningful, productivity-enhancing investments in infrastructure, education and
job training. If their economies are to grow in the future, Eurozone countries must become
more competitive with the rapidly expanding economies of Asia, Eastern Europe, and
elsewhere in the developing world.

In the medium-term, the Eurozone countries must demonstrate a commitment to fiscal

restraint and more balanced budgets. Eliminating loopholes that allow businesses and
wealthy individuals to avoid paying taxes, for example, is of utmost importance. Also,
increasing the retirement age, downsizing some of the more generous social welfare
programs and increasing marginal tax rates on the highest income earners would all send
the message to investors that these countries are committed to fiscal discipline. Then, in
time, their dependence on ECB lending will decline and private lenders will once again be
willing to buy Eurozone government bonds at lower interest rates, allowing for continued
growth in the private sector.