SUMMARY ECONOMICS

Y2Q1

Glenn Bttcher
Summary Economics

Chapter 26 Saving, Investment and the financial system

Financial system: The group of institutions in the economy that help to match one persons saving with another
persons investment. The financial system is the system that enables lenders and borrowers to exchange funds
(Banks, relatives, monetary funds and other financial institutions). The financial system moves the economys scarce
resources from savers to borrowers.
Interest rate: The price that adjusts to balance supply and demand.
Financial institutions in the economy
At the broadest level, the financial system moves the economys scarce resources from savers (people who spend
less than they earn) to borrowers (people who spend more than they earn). Savers supply their money their money
to the financial system with the expectation that they will get it back with interest at a later date.
Financial markets
Financial markets: Financial institutions through which savers can directly provide funds to borrowers.
The bond market

Bond (debt) market Wertpapiere, a loan that has to be paid back in a certain time.
o A bond is a certificate of indebtedness that specifies obligations of the borrowers to the holder of
the bond.
Characteristics:
Term: the length of time until the bond matures (the time at which the bond will be
paid back), rate of interest Long-term bonds are riskier than short-term bonds,
because the borrower has to wait longer for his money.
o Perpetuity: A bond that never matures.
Credit risk: the probability that the borrower will fail to pay some of the interest
principal higher interest rate to compensate them from this risk. Governmental
bonds have the less risk, and the lowest interest rate.

Stock (equity) market it represents a claim to partial ownership in a firm and is therefore, a claim to the
profits that the firms makes.
o The sale of stock to raise money is called equity financing.
Compared to bonds, stocks offer both higher risk and potential higher returns.
o Stocks are traded on exchanges such as the London stock exchange and the Frankfurt stock
exchange.
The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt finance. If a
company is very profitable, the shareholder enjoys the benefits of these profits, whereas the bondholder gets only
the interest of their bonds. And if the company runs into financial difficulty, the bondholder is paid what he was due
before shareholders receive anything at all.
Financial intermediaries
Financial institutions through which savers can indirectly provide funds to borrowers
Banks
A primary function of banks is to take in deposits from people who want to save and use these deposits to make loan
for people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher
interest rates on their loans. Furthermore, banks help create a special asset that people can use as a medium of
exchange.
Investment funds Insurance companies, pension funds etc. Commented [GB1]: Further explanations
An institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. The
primary advantage of investment funds is that they allow people with small amounts of money to diversify. People
who hold a diverse portfolio of shares and bonds face less risk because they have only a small stake in each
company. A second advantage is that investment funds give ordinary people access to the skills pf professional
money managers.
Credit default swaps (CDS): Swapping the risk of not receiving the bond issued to someone by an insurance
company. The negotiated interest rate will be paid to the insurance company in order to receive the bond if the
borrower is not able to pay back the bond.
Money market (divided into wholesale money market and retail money market) & Capital market (divided into
official capital market and private capital market)
Money: Assets with a maturity with less than 2 years
o Wholesale money market: big market parties interest rate: Euribor/Libor (UK)
o Retail money market: SMEs interest rate: credit (depositing your money in a bank) debit rate (if Commented [GB2]: Further explanations
you are taking a loan from a bank).
Capital: Assets with a maturity with more than 2 years
o Official capital market: conditions are publicly announced.
o Private capital market: direct negotiations between parties.
Calculation interest yields (M&H Ch. 8)
Coupon rate (nominal rate)
Coupon / flat yield
Effective yield
Example pa.219/220

Saving and investment in the National Income Accounts

The institutions that make up this system the bond market, the stock market, banks and investment funds have
the role of coordinating the economys saving in investment Saving and investment are important determinanats
of long-run growth in GDP and living standards.
GDP is both total income in an economy and total expenditure on the economys output of goods and services:
Y (INCOME GDP)= C (Consumption done by consumers)+I (Investment by firms) +G
(Government expenses)+NX (Net exports)
This equation is an identity because every euro of expenditure that shows up pn the left-hand side also shows up in
one of the four components on the right-hand side.
Closed economy: One that does not engage in international trade Y=C+I+G Imports and exports are exactly zero.
Open economies: Economies that interact with other economies around the world.
To see what this identity can tell us about financial markets, subtract C and G from both sides of this equation. We
obtain:
Y-C-G=I
The left-hand side is the total income in the economy that remains after paying for consumption and government
purchases: this amount is called national savings S (Y-C-G) = I
This equation states that saving equal investment. Let T denote the amount that the government collects from its
households in taxes minus the amount it pays back to households in form of transfer payments (such as social
security payments). Then we can write: S = Y C G or S = (Y T C) + (T G). This equations are the
same, because the two Ts in the second equation cancel each other, but each reveals a different way of thinking
about national savings. The second equation separates national savings into private saving (Y T C) and public
savings (T G).
Private saving: The income that households have left after paying for taxes and consumption.
Public saving: The tax revenue that the government has left after paying for its spending. The government receives T
in tax revenues and spends G on goods and services. If T exceeds G, the government runs a budget surplus because it
receives more money than it spends. This surplus represents public saving.
The market for loanable funds
We assume, that the economy has only one financial market, called the market of loanable funds: The market in
which those who want to save supply funds and those who want to borrow to invest demand funds.
Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their
own consumption. In the market for lonable funds, there is one interest rate, which is both the return to
saving and the cost of borrowing.
o Real interest rate: calculated without inflation
o Nominal interest rate: calculated with inflation
Supply and demand for loanable funds
The supply of loanable funds comes from those people who have some extra income they want to save and lend
out. Saving is the source of supply.
The demand for loanable funds comes from households and firms who wish to borrow to make investments.
Investment is the source of demand.
The interest rate is the price of the loan.
It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.
The interest rate in the market for loanable funds is the real interest rate. The real interest
rate is the nominal interest rare corrected for inflation; it equals the nominal interest rate
the inflation rate.
o And the equilibrium of the supply and demand for loanable funds determines the real interest rate.
o Because a high interest rate makes borrowing more expensive, the quantity of loanable funds
demanded falls as the interest rate rises because a high interest rate makes saving more
attractive, the quantity of loanable funds supplied rises as the interest rate rises.

Governmental policies that affect savings and investment

o Saving incentives Saving is an important long-run determinant of a nations productivity. Hence, if
a country can raise its saving rate, the growth rate of GDP should increase and, over time, the
citizens of that country should enjoy a higher standard of living.
o Investment incentives
o Government Spending (Budget Deficits and Surpluses)
Policy 1: Saving incentives (This affects the demand curve, because the tax change would alter the incentive for
households to save and supply the borrowers).
Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce
the incentive to save.
A tax decrease on savings increases the incentive for households to save at any given interest rate.
If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.
Policy 2: Investment incentives (The demand curve is affected, because the tax credit would reward firms that
borrow and invest in new capital, it would alter investment, thereby, change the demand for loanable funds).
An investment tax credit gives tax advantage to any firm building a new factory or buying a new piece of
equipment. It increases the incentive to borrow.

If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.
Policy 3: Government Spending (Budget Deficits and Surpluses)
When the government spends more than it receives in tax revenues, the short fall is called the budget
deficit.
The accumulation of past budget deficits is called the government debt.
What happens to supply and demand of loanable funds when government starts having budget deficit?
The government needs to borrow money! T-G= Negative. The supply curve will shift to the left, because the
government borrows money to finance its deficit. This fall in investment is referred to as crowding out.
o The deficit borrowing crowds out private borrowers who are trying to finance investments.

When government reduces national saving by running a deficit, the interest rate rises and investment falls.
A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates
investment.
Chapter 29 The Monetary System
The meaning of money
Money: The set of assets in an economy that people regularly use to buy goods and services from other people.
According to the economists definition, money includes only those few types of wealth that are regularly accepted
by sellers in exchange for goods and services.
The functions of money
1. Medium of exchange: An item that buyers give to sellers when they want to purchase goods and services. A
medium of exchange is anything that is readily acceptable as payment.
a. You buy a T-shirt and pay with money in exchange
2. Unit of account (Rechnungseinheit): The yardstick people use to post prices and record debts, the
measurement of value.
a. A sandwich costs 2 and a T-shirt 10 and not 5 sandwiches.
3. Store of value: An item that people can use to transfer purchasing power from the present to the future. Its
value stays for a longer period of time, it can be stored and used later.
a. When a seller accepts money today in exchange for a good or service, that seller holds the money
and becomes a buyer of another good or service at another time.
Liquidity: The ease with which an asset can be converted into the economys medium of exchange (Money for
example). Money is the most liquid asset available in the monetary system, because it is directly available. Selling a
car takes more time, this asset is less liquid.
When prices rise, the value of money falls, each euro in your wallet can buy less.

The kinds of money

Commodity money: Money that takes the form of a commodity with intrinsic value
Gold or silver, and cigarettes for example because they have value in themselves.

Fiat money: Money without intrinsic value that is used as money because of government decree.
Coins, currency and account deposit for example because a value is only imposed on it.

Money in the economy

What is included if you measure the quantity of money in an economy, being a part of the money stock?
1. Currency: The paper banknotes and coins in the hands of the public. Currency is clearly the most widely
accepted medium of exchange.
Demand deposit: Balances in bank accounts that depositors can access on demand by using a debit card or
writing a cheqeue.
a. Payment by debit-card, which allows money to be transferred electronically.
b. Writing a personal cheques to transfer money between two accounts.
c. The balance on your account in order to pay with the credit-card due to the fact that a payment
with a credit-card defers the actual transfer of the money. The money will be taken at the end of a
month from the account.

Three measures of the money stock for the Euro Area

The three measures of euro area money stock are M1 (a narrow monetary agreement that comprises currency in
circulation and overnight deposit), M2 (an intermediate monetary aggregate that comprises M1 plus deposits with
an agreed maturity of up to two years and deposits redeemable at notice of up to three months) and M3 (a broad
monetary aggregate that comprises M2 plus repurchase agreements, money market fund shares and units as well as
debt securities with a maturity of up to two years) (2010).
The role of central banks
Central bank: An institution designed to regulate the quantity of money (fiat money) in the economy.

Money supply: The quantity of money available in the economy.

Monetary policy: The set of actions taken by the central bank in order to affect the money supply.
Rising taxes in order to take peoples money or printing notes in order to reduce the value of the money.

Open-market operations: The purchase and sale of non-monetary assets from and to the banking sector by the Commented [GB3]: What is meant by that?
central bank.

The central bank of an economy is an important institution because changes in the money supply can profoundly
affect the economy.
Prices rise when too much money is printed.
The society faces a short-term tradeoff between inflation and unemployment.
The power of the central bank rests on these principles and is often seen as a guardian of price stability, or more
inflation stability (because even low inflation rates increase prices) in a modern economy.

The European Central Bank and the Eurosystem

European Central Bank (ECB): The overall central bank of the 16 countries comprising the European Monetary
Union.
Bringing together with the same currency and applying to the same monetary policy.
The primary objective of the ECB is to promote price stability, throughout the euro area and to design and
implement monetary policy that is consistent with this objective.
The ECB was officially created on 1 June 1998 and is located in Frankfurt
It came into being because 11 countries of the European Union had decided that they wished to enter
European Monetary Union and use the same currency
An important feature of the ECB is its independence

Eurosystem: The system made up of the ECB plus the national central banks of each of the 16 countries comprising
the European Monetary Union.

Banks and the monetary supply

Because demand deposits are held in banks, the behavior of banks can influence the quantity of demand deposits in
the economy and, therefore, the money supply.

Reserves: Deposits that banks have received but have not loaned out.
Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving
the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of
money.
o Money was paid into the bank and is still on the account, it becomes demand deposit.
o Money deposit = demand deposit.
o It is always calculated with the deposit (liabilities).

In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the
rest.

If the flow of new deposits is roughly the same as the flow of withdrawals, the bank needs to keep only a
fraction of its deposit in reserve.

Reserve ratio: The fraction of deposits that banks hold as reserves. This ratio is determined by a combination of
government regulation and bank policy.

When a bank makes a loan from its reserves, the money supply increases.

The money supply is affected by the amount deposited in banks and the amount that banks loan.
 o Deposits into a bank are recorded as both assets and liabilities.
o The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
o Loans become an asset to the bank.

When one bank loans money, that money is generally deposited into another bank.
o This creates more deposits and more reserves to be lent out.
o When a bank makes a loan from its reserves, the money supply increases.

At the end of this process of money creation, the economy is more liquid in the sense that there is more of the
medium of exchange, but the economy is no wealthier than before.
An increase in the reserves increases a surplus of bank liquid assets.

The money multiplier

The creation of money does not stop with First European Bank (FEB). Suppose the borrower from FEB uses the 90
to buy sth. From someone who then deposits the currency in Second European Bank (SEB). For further explanation,
please refer to P. 629 of the book.

Money multiplier: The amount of money the banking system generates with each unit of reserves. In the example
above, the money multiplier is 10.
What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the
reciprocal of the reserve ratio. The R is the reserve ratio for all banks in the economy, then each euro of reserves
generates M = 1/R euros of money. With a reserve requirement, R = 20% or 1/5, the multiplier is 5.

The Central Banks Tools of Monetary Control

The central bank is responsible for controlling the supply of money in the economy. Because banks create money in
a system of fractional-reserve banking, the central banks control of the money supply is indirect.
In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend
out the rest

In general, a central bank has three main tools in its monetary toolbox:

Open-market Operations
A central bank conducts open-market operations when it buys government bonds from, or sells government bonds
to the public.
When the central bank buys government bonds, the money supply increases and
The money supply decreases when the central bank sells government bonds

The refinancing rate

The refinancing rate is the interest rate the ECB lends on a short-term basis to the euro area banking sector.
Increasing the refinancing rate decreases the money supply
Decreasing the refinancing rate increases the money supply
In the USA, the refinancing rate is called the discount rate and in the UK it is called the repo rate.

Repurchase agreement (repo): The sale of a non-monetary asset together with an agreement to repurchase it at a
set price at a specified future date.
 Commercial banks sell assets to the central bank in order to provide more money to its clients, with the
agreement of buying the assets back after a short period of time.

Money market: The market in which the commercial banks lend money to one another on a short-term basis when
the reserve ratio of some banks is too low and others, with a more reserves, are able to compensate this holes. This
is done to be liquid permanently.

Reserve requirements
The central bank may also influence the money supply with reserve requirements, which are regulations on the
minimum amount of reserves that banks must hold against deposit.
Increasing the reserve requirement decreases the money supply
Decreasing the reserve requirement increases the money supply
Central banks have tended to change reserve requirements only rarely and the Bank of England no longer sets
reserve requirements at all.

Problems in Controlling the Money Supply

A central banks control of the money supply is not precise.
A central bank must wrestle with two problems that arise due to fractional-reserve banking.
The central bank does not control the amount of money that households choose to hold as deposit in banks.
o The more money people deposit, the more reserves the banking system has in order to create
money
The central bank does not control the amount of money that bankers choose to lend
o When money is deposited in a bank, it creates more money only when the bank lends it out.
Because banks can choose to hold reserves instead, the central bank cannot be sure how much
money the banking system will create.
With fewer loans, the money supply falls.
Chapter 30 Money Growth and Inflation (P.641 661)
Inflation: In increase in the overall level of prices.
The money used to buy something decreased in its value.

Hyperinflation: An extraordinarily high rate of inflation.

Deflation: A decrease in the overall level of prices.

Inflation: Historical Aspects

Inflation in the UK exceeded 20% per year in the mid-1970s, but nowadays it has been low and stable at
around 2% per year.
In Eurozone, prices rose by 0.3% in August 2014.
For long periods in the nineteenth century, some countries experienced deflation, meaning decreasing
average prices.
Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s and Zimbabwe in
2007-08.

The classical theory of inflation

Quantity theory of money: A theory asserting that the quantity of money available determines the price level and
that the growth rate in the quantity of money available determines the inflation rate.

The level of prices and the value of money

Inflation is an economy-wide phenomenon that concerns, first and foremost, the value of the economys medium of
exchange. When the overall price level rises, the value of money falls. The economys price level can be viewed in
two ways:
The price level of as the price of a basket of goods and services
o When price levels rise, people have to pay more for goods and services they buy
The price level as a measure of the value of money
o A rise in the price level means a lower value of money because each unit of money now buys a
smaller quantity of goods and services
Suppose P is the price level. P measures the number of euros needed to buy a basket of goods and services. The
quantity of goods and services that can be bought with 1 equals 1/P. If P is the price of goods and services
measured in terms of money, 1/P is the value of money measure in terms of goods and services.

Money supply, Money demand and monetary equilibrium

Just as the supply and demand for bananas determines the price of bananas, the supply and demand for money
determines the value of money.
Money supply
The money supply is a policy variable that is controlled by the central bank.
When the central bank sells bonds in open-market operations, it receives money in exchange and contracts
the money supply. When it buys bonds, the money supply is expanded.

Money demand
The demand for money reflects how much wealth people want to hold in liquid form. The amount of currency
people hold in their wallet depends on how much they rely on credit cards. Furthermore, it has several other
determents, such as the interest rate that a person could earn by using the money to buy bonds, rather than leaving
the money in the wallet, as well as the average level of prices in the economy.
People hold money because it is the medium of exchange.
How much money they choose to hold depends on the prices of goods and services they want to buy.
o A higher price level (a lower value of money) increases the quantity of money demanded.

Monetary equilibrium
In the short run, Central Banks uses interest rates to balance the money supply and demand.
In the long run, the overall level of prices adjusts to the level at which the demand for money equals supply.

The supply curve is vertical because the central bank has fixed the quantity of money available. The demand curve of
money is downward sloping, indicating that when the value of money is low (and prices are high), people demand a
larger quantity of it to buy goods and services.

The effects of a monetary injection

Printing as twice as much is available and spreading it throughout the whole country
Buying some government bonds form the public in open-market operations.

When an increase in the money supply makes euros more plentiful, the result is an increase in the price level that
makes each euro less valuable. This explanation is called quantity theory of money: A theory asserting that the
quantity of money available determines the price level and that the growth rate in the quantity of money available
primary causes the inflation rate.

The classical dichotomy and monetary neutrality

To see how changes in monetary affects other macroeconomic variables, all economic variables are suggested to be
divided into two groups.
1. Nominal variables: Variables measured in monetary units
a. Income of corn farmers (measured in euros)
2. Real variables: Variables measured in physical units
a. Quantity of corn produced (measured in kilos)
This division is called classical dichotomy The theoretical separation of nominal and real variables. This division is
necessary to useful analyze the economy because different forces influence real and nominal variables.
Nominal GDP is a nominal variable because it measures the euro value of the economys output of goods and
services; real GDP is a real variable because it measures the total quantity of goods and services produced and is not
influences by the current prices of those foods and services.

According to various economists, real economic variables do not change with changes in the money supply in the
long run that changes in the money supply affect only nominal variables.
The irrelevance of monetary changes for real variables is called monetary neutrality (production, employment and
real wages are unchanged due to changes in the money supply).
Example: If a member from the EU decides to change the definition of a meter from 100 to 50 cm as a result of the
new unit of measurement, all measured distances (nominal variables) would double, but the actual distance (real
variables) would remain the same.

Velocity and the quantity equation

Velocity of money: The rate at which money changes hands as it moves around the economy.
V = (P x Y) / M
V = Velocity
P = the price level
Y = Quantity of output (real GDP)
M = Quantity of money
(Example on P. 649)

Y stands for the real GDP and it represents the physical goods and services and their values that are produced. The
amount of goods and services that can be produced are determined by the production and state of technology.
The amount of goods and services is fixed in the short run (Quantity theory).
Price x quantity is the nominal value of that item PY is nominal, price level.
Velocity & real GDP, Y, are assumed to be constant in the short run.

Quantity equation: The equation M x V = P x Y, which relates the quantity of money, the velocity of money, and the
currency value of the economys output of goods and services.
MxV=PxY
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of
the other three variables.
1. The price level must rise
2. The quantity of output must rise
3. The velocity of money must fall

Explanation of the equilibrium price level and inflation rate.

1. The velocity of money is relatively stable over time
2. Because V is stable, when the central bank (CB) changes M, it causes proportionate changes in the nominal
value of output (P x Y).
3. Because money is neutral, it does not affect output (output is determined by factors suppliers, such as labor,
human capital etc).
4. A change in money supply (M) is reflected in a change in the price level (P).
5. When the CB increases M rapidly, the result is a high rate in inflation.

Money and prices during 2 hyperinflations

The inflation tax
Inflation tax: The revenue the government raises by creating money (The inflation tax occurs due to high
government spending and limited ability to borrow).
The inflation tax is not like other taxes, because no one receives a bill from the government for this tax.
Instead, the inflation tax affects everyone who holds money, due to an increase in the prices by printing money. The
inflation ends when the government institutes fiscal reforms such as cuts in government spending.

The Fisher effect

The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.
According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.
The real interest rate stays the same.
The nominal interest rate is the interest rate that takes inflation into consideration
Nominal interest rate = Real interest rate + Inflation rate

The real interest rate corrects the nominal interest rate for the effect of inflation.
Real interest rate = Nominal interest rate Inflation rate
Chapter 31 Open-economy Macroeconomics: Basic Concepts
There are clear benefits to being open to international trade: trade allows people to produce what they best and to
consume the great variety of goods and services around the world.
Closed economy: An economy that does not interact with other economies in the world.
Open economy: An economy that interacts freely with other economies around the world.
An open economy interacts with other countries in two ways
o It buys and sells goods and services in world product markets
o It buys and sells capital assets in world financial markets.

The flow of goods and service: Exports, Imports and Net exports
Net exports (NX) are the value of a nations exports minus the value of its imports
Net exports are also called trade balance (Exports - Imports).
o Sales of Lloyds insurances abroad increases the UKs net export
A trade deficit is a situation in which net exports are negative
Imports > Exports trade deficit
A trade surplus is a situation in which net exports are positive
Imports < Exports trade surplus
Balanced trade: A situation in which exports equal imports.

Factors that affect net exports

Taste of consumers for domestic and foreign goods
The price of goods at home and abroad
The exchange rates at which people can use domestic currency to buy foreign currencies
The incomes of consumers at home and abroad
The costs of transporting goods from country to country
Government policies toward international trade
As these variables change over time, so does the amount of international trade.

With total exports as a measure of world trade, we can see that trade has grown about 3.75 times as fast as world
output. This shows the increasing importance of international trade and finance in the world economy.
Only exports are shown, because they are inputs at the same time of other countries.
Growth in international trade is measured by exports.
This increase in international trades partly due to improvements in transportation.
Increase due to advances in telecommunications.
Technological improvements by changing the kinds of goods and services.
o Goods produced with modern technology are easier to produce and have lower weight less
expensive for transportation
National and international trade policies have also been a factor in increasing international trade.
More goods and services, which are cheaper good for domestic production, you also sell to other countries
(positive GDP increase) The more open you are, the richer you are.
The flow of financial resources: Net Capital Outflow
Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic
assets by foreigners. Positive term, more goods go out of the country
A Dutch resident buys share in the BMW (capital outflow) and a French resident buys a bond issued by the
Dutch government (capital inflow).

The flow of capital abroad takes two forms:

1. A French car manufacturer opens up a factory in Romania direct investment (active)
2. A French citizen buys shares in a Romanian company foreign portfolio investment (passive)

Variables that influence net capital outflow:

The real interest rates being paid on foreign assets and domestic assets (price you put on financial assets)
The perceived economic and political risks of holding assets abroad
The government policies (taxes) that affect foreign ownership of domestic assets.
o If domestic interest rates are below international interest rates, the cash outflow decreases, and
cash inflow will increase because more people invest in the country.

Example: A Germany investor wants to buy Mexican bonds.

He compares the real interest rates (the higher, the better)
How high is the risk that the government might default on its debt?
Any restrictions of political policies now or in the future provide extra risk

The equity of net exports and net capital outflow

An open economy interacts with the rest of the world in two ways:
1. In world markets for goods and services
2. In world financial markets

Net exports measures an imbalance between a countrys exports and its imports.
Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic
residents and the amount of domestic assets bought by foreigners.
For an economy as a whole, net capital outflow (NCO) always equals net exports (NX):

NCO = NX

This holds true because every transaction that affects one side must also affect the other side by the same amount.
The equality of net exports and net capital outflow follows from the fact that every international transaction is an
exchange.
Ex: A good in exchange for currency.

Saving and investment, and their relationship to the international flows

Net exports is a component of the GDP:

Y = C + I + G + NX

Total expenditure in the economys output of goods and services is the sum of expenditure on consumption,
investment, government purchases and net exports.
National saving is the income of the nation that is left after paying for current consumption and government
purchases
Y C G = I + NX
S = I + NX
Or
S = I + NCO
S = Saving
I = Domestic investment
NCO = Net capital outflow

When UK citizens save a pound of their income for the future, that pound can be used to finance
accumulation of domestic capital or it can be used to finance the purchase of capital abroad (Another
example on P. 672)

Because net exports are exports imports, net exports (NX) are greater than 0. As a result, income (Y = C + I
+ G + NX) must be greater than domestic spending (C = I + G). But if Y is more than C + I + G, then Y C G
must be more than I. That is, savings (S = Y C G) must exceed investment. Because the country is saving
more than it is investing, it must be sending some of its saving abroad. That is, the net capital outflow must
be greater than 0.

The prices for international transactions: real and nominal exchange rates
International transactions are influenced by international prices
The two most important prices are the nominal exchange rate and the real exchange rate

Nominal exchange rate

The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of
another.
It is either expressed:
In units of foreign currency per euro 1/125 (=0.01)
Or in euros per unit of the foreign currency

Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can
buy.
The exchange rate changes so that a euro buys more of another currency
Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can
buy.
The exchange rate changes so that a euro buys less of another currency

When economists talk about the euro or the pound appreciating or depreciating, they often are referring to an
exchange rate index that takes into account many individual exchange rates.
Real exchange rate
The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods
and services of another.
A kilo of Swiss cheese is twice as expensive as a kilo of English cheddar cheese The real exchange rate is a
kilo of Swiss cheese per kilo of English cheese.

Real exchange rate = (Nominal exchange rate x Domestic price) / (Foreign price)

Example: Real exchange arte (2 per pound) x (1$ per kilo of UK wheat) / 3 per kilo of European what
= 1/3 kilo of European what per kilo of UK wheat.

The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries
measured in the local currencies. The real exchange rate is is a key determinant of how much a country exports and
imports.
If you decide where to go on holiday by comparing costs, you are basing your decision on the real exchange rate.

A depreciation in Eurozone RER Goods in Eurozone become cheaper rel. to foreign goods Exports increase, and
imports decrease NX of Eurozone increases (more people invest)

A FIRST THEORY OF EXCHANGE RATE DETERMINATION: PURCHASING POWER PARITY

According to the purchasing power parity theory, a unit of any given currency should be able to buy the same
quantity of goods in all countries.
PPP is based on the law of one price: a good must sell for the same price in all locations.
A currency must have the same purchasing power in all countries and exchange rates move to ensure that.

The nominal exchange rate between the currencies of two countries must reflect the different price levels in those
countries.
ePPP = P*/P
P* = Foreign price (basket)
P = home price (basket)

If the nominal exchange rate > ePPP

Currency is overvalued
If the nominal exchange rate < ePPP
Currency is undervalued

ePPP (purchasing power) = P* (foreign prices) / (domestic prices)

Implications of purchasing power parity
The nominal exchange rate between the currencies of two countries depends on the price levels in those countries.
If a euro buys the same quantity of goods in Germany () as in Japan (Yen), then the number of yen per euro must
reflect the prices of goods in Germany and Japan.
A kilo coffee is priced at 500 yen and 5 (500 / 5 = 100 yen per euro).

P = price of a basket in the domestic country ()

P* = orice of a basket in the foreign country (yen)
E = nominal exchange rate (the number of yen needed to buy one euro)

In the home country, price level is P, so the purchasing power is 1/P

Abroad, the euro can be exchanged into e units of foreign curreny, which in turn have purchasing power e/P*.

1/P = e/P*

With rearrangement

1 = eP / P*

Left is a constant, and right the real exchange rate.

For the nominal exchange rate:

E = P* / P

The nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to
the theory of purchasing power parity, the nominal exchange rate between the currencies of two countries must
reflect the different price levels in those countries.
Nominal exchange rates change when price levels change. Because the nominal exchange rate depends on the price
level, it also depends on the money supply and money demand in each country.

Common currency area: A geographical area, possibly covering several countries, in which a common currency is
used.

Limitations of purchasing power parity

Exchange rates do not always move in the same direction that theory suggests
Many goods are not easily traded or shipped from one country to another
Tradable goods are not always perfect substitutes when they are produced in different currencies.
Chapter 32 A Macroeconomic Theory of the open economy
To understand what factors determine a countrys trade balance and how government policies can affect it, we need
a macroeconomic theory of open economy.
This chapter develops a model that identifies the forces that determine net exports, net capital outflow, and the real
and nominal exchange rates and shows how these variables are related to one another.
1. GDP is given
2. The economys price level is given
The goal of the model is to highlight the forces that determine the economys trade balance and exchange rate.

Supply and demand for loanable funds and for foreign currency exchange
The first is the market for loanable funds, which coordinates the economys saving, investment and the flow of
loanable funds abroad (called the net capital outflow.
The second is the market for foreign currency exchange, which coordinates people who want to exchange the
domestic currency for the currency of other countries.

The market for loanable funds

To understand the market for loanable funds in an open economy, the place to start is the identity:

S = I + NCO

The supply for loanable funds come from national saving (S). The demand for loanable funds comes from domestic
investment (I) and net capital outflow (NCO). The quantity for loanable funds supplied and the quantity of loanable
funds demanded depends on the real interest rate
A higher interest rate encourages people to save
A higher interest rate discourages investment
In addition to influence national saving and domestic investment, the real interest rate in a country affects that
countrys net capital outflow.
An increase in the UK real interest rate discourages Brits from buying foreign assets and encourages people
living in other countries to buy UK assets. A high real interest rate reduces UK net capital outflow.
The demand for loanable funds come not only from those who want loanable funds to buy domestic capital goods
but also from those who want loanable funds to buy foreign assets.
The interest rate adjusts to bring the supply and demand for loanable funds into balance. At the equilibrium interest
rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net
capital outflow.
The market for foreign currency exchange

NCO = NX

This identity states that the imbalance between the purchase and sale of capital assets abroad (NCO) equals the
imbalance between exports and imports of goods and services (NX).
Net capital outflow represents the quantity of pounds supplied for the purpose of buying foreign assets
(supplying pounds in the market for foreign currency exchange).
Net exports represent the quantity of pounds demand for the purpose of buying UK net exports of goods
and series (demanding pounds in the market for foreign currency exchange).
The real exchange rate balances the supply and demand in the market for foreign currency exchange.
The real exchange rate is the relative price of domestic and foreign goods and, therefore a key determinant
of net exports
o An appreciation of the real exchange rate reduces the quantity of pounds demanded in the market
of foreign currency exchange
The demand curve slopes downward because a higher exchange rate makes domestic goods more expensive

A higher exchange rate makes UK goods more expensive and reduces the quantity of pounds demanded to
buy those goods.
The supply curve is vertical because the quantity of pounds supplied for net capital outflow does not depend on the
real exchange rate (price of for example).
Net capital outflow is determined in the market of loanable funds.

The real exchange rate adjusts to balance the supply and demand for pounds just as the price of any good
adjusts to balance supply and demand for that good.
At the equilibrium real exchange rate, the demand for pounds by non-UK residents arising from the UK net
exports of goods and services exactly balances the supply of pounds from UK residents arising from UK net
capital outflow
o UK resident imports a car, the model threats that transaction as a decrease in the quantity of pounds
demanded (because net exports fall)
o Japanese resident buys a UK government bond, the model threats that transaction as a decrease in
the quantity of pounds supplied (because net capital outflow falls).
The theory of purchasing power parity (preceding chapter) assumes that the net exports are highly
responsive to small changes in the real exchange rate

Equilibrium in the open economy

Lets now consider how the market for loanable funds and the market for foreign currency exchange are related to
one another.
Net capital outflow: The link between the two markets
Net capital outflow links the loanable funds market and the foreign currency exchange market.
In the market for loanable funds, net capital outflow is a piece of demand
o A person who wants to buy an asset abroad must finance this purchase by obtaining resources in the
market for loanable funds
In the market for foreign currency exchange, net capital outflow is the source of supply
o A person who wants to buy an asset in another country must supply pounds in order to exchange
them for the currency of that country
The key determinant of net capital outflow is the real (domestic) interest rate.

Simultaneous Equilibrium in two markets

Prices in the loanable funds market (real interest rate) and the foreign currency exchange market (real
exchange rate) adjust simultaneously to balance supply and demand in these two markets.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net
foreign investment (net capital outflow), and net exports.

Panel (b) shows how the interest rate from panel (a) determines net capital outflow.
Because foreign assets must be bought with foreign currencies, the quantity of net capital outflow from
panel (b) determines the supply of pounds to be exchanged into foreign currencies.
 Because a depreciation of the real exchange rate increases net exports, the demand curve for foreign
currency exchanges slopes downward.

How policies and events affect an open economy

The model is just supply and demand in two markets the market for loanable funds and the market for
foreign currency exchange.
Steps, regarding how policies and events affect an open economy
1. Which of the supply and demand curves the events affect
2. Determine which way the curve shifts
3. Use the supply-and-demand diagrams to examine how these shifts alter the economys equilibrium

Government budget deficit

The magnitude and variation in important macroeconomic variables depend on the following:
Government Budget deficit
(Trade policies)
Political and economic stability
In an open economy, government budget deficits
Reduce the supply of loanable funds
Drive up interest rate
Crow out domestic investment
Cause net foreign investment (NCO) to fall

A government budget deficit reduces national saving, which

o Shifts the supply curve for loanable funds to the left, which
raises interest rates
Higher interest rates reduce net foreign investment
A decrease in net foreign investment reduces the supply of euros to be exchanged into foreign currency
This causes the real exchange rate to appreciate

Political instability and capital flight

Capital flight: A large and sudden reduction in the demand for assets located in a country
 Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects
other countries.
If investors become concerned about the safety of their investments, capital can quickly leave an
economy.
Interest rates increase and the domestic currency depreciates.
When investors around the world observed political problems in Mexico in 1994, they sold some of their
Mexican assets and used the proceeds to buy assets of other countries.
This increased Mexican net capital outflow.
o The demand for loanable funds in the loanable funds market increased, which increased the
interest rate.
o This increased the supply of pesos in the foreign currency exchange market.

European Union

Political objective
Uniting Europe
 Supranational cooperation (Euratom and Eur. Coal and Steel Community)
Intergovernmental cooperation: national governments of EU member states have final say over issues, veto
right, unanimously votes, EU foreign policy, security, home affairs and justice; why: member states want to
maintain sovereign say over national issues;
Intergovernmentalism vs federalism (eg. Germany and USA: one central government, one prime-
minister/president with overall say over key issues, but some issues left to federal states)
EU: econ. Cooperation: EU law rules over national laws

Power EU: federalism vs intergovernmentalism

Federalism: further econ. integration that goes hand in hand with political integration (Germany, USA). EU policies
must be developed and run by supranational institutions beyond national states (eg. ECB setting the monetary policy
in the Euro zone). EU is quasi-state and member countries must give up power; create supranational institutes (ECB),
only majority voting and not principle of unanimity).
Intergovernmentalism: each member state maintains its political sovereignty, right to veto. Collaboration only in
case of unanimously agreement.
Euratom and ECSC are the few examples of supranational cooperation; majority voting, no veto right

Subsidiarity principle in the EU

Subsidiarity principle is seen as an economic advantage of federalism in the EU. It ensures that decisions are being
taken as closely as possible to the citizens: to overcome the democratic deficit gap; and that constant
checks are made to verify that action at the EU level is justified in the light of the possibilities to take decisions at the
national, regional or local level of EU member states. It is the principle whereby the EU does not take action (with
the exception in the areas in which it has its exclusive competence), unless it is more effective than action taken at
the national, regional or local level.

Budget Revenues
Traditional resources (custom duties on EU import products, e.g. Sugar levies)
% of VAT resources
% of GNP of member states
Mescellaneous

Impact of the EU
EU proposals to decrease mobile roaming charges
Over 1.5 million students have received an ERASMUS grant and spent a part of their course studying in
another country
EU has enabled airlines to compete against each other (liberalization)
The single currency for the euro area: Easier travelling and lower prices
Free movement of people
 Free movement of capital
Free movement of products

Chapter 1 Why the EU?

The EUs mission in the 21st century is to:

Maintain and build on the peace established between its members states
Bring the European countries together in practical cooperation
Ensure that European citizens can live in security
Promote economic and social solidarity
Preserve European identity and diversity in a globalized world
Promulgate the values that European share
Peace
The European Union was a dream of United States of Europe.
After WW2, 1945 and 1950, a handful of courageous statesmen including Robert Schuman, Konrad Adenauer, Alcide
de Gasperi and Winston Churchill set about persuading their peoples to enter a new era. New structures would be
created in Western Europe, based on shared interests and founded upon treaties guaranteeing the rule of law and
equality between all countries. Robert Schuman and Jean Monnet, in 1950, established a European Coal and Steel
Community (ECSC). Raw materials of war were being turned into instruments of reconciliation and peace.

Bring Europe together

The European Union encouraged German unification after the fall of the Berlin Wall in 1989. When the Soviet empire
crumbled in 1991, the countries of central and Eastern Europe were once again free to choose their own destiny.
Eight of them joined the EU in 2004, and two more in 2007.
The process of EU enlargement is still going on.

Security
The EU has to take effective action to ensure the security of its member states. It must also protect its military and
strategic interests by working with its allies, especially within NATO, and by developing a genuine common
European security and defense policy.
Making the EU an area of freedom, security and justice where everyone has equal access to justice and is equally
protected by the law is a new challenge that required close cooperation between governments.

Economic and social solidarity

European countries account for an ever smaller percentage of the worlds population. They must therefore continue
pulling together if they are to ensure economic growth and be able to compete on the world stage with other
major economies. European companies need a broader base than just their national home market, and the
European single market provides it (500 million consumers). To ensure benefits for everyone, the EU is endeavoring
to remove obstacles to trade and is working to free business from unnecessary red tape, by solidarity. The Structural
Funds, managed by the European Commission, encourage and supplement the efforts of the EUs national and
regional authorities to reduce inequalities between different parts of Europe (natural disasters). Money from the
EU budget and loans from the European Investment Bank (EIB) are used to improve Europes transport
infrastructure (extending motorways and high-speed railways), thus providing better access to outlying regions and
boosting trans-European trade.

The big challenge for European countries in the years ahead will be to stand together in the face of global crises &
public debt and to find out, together, a way out of recession and into sustainable growth.

European identity and diversity in a globalized world

The EU countries need to work together to tackle problems, like gaps between rich and poor, unequal rising
standards of living, industrial relocation, recession. The EU as a whole is greater than the sum of its parts. It has
much more economic, social, technological, commercial and political clout than if its member states had to act
individually.
To maintain their influence on the world stage as a critical mass, they must come together.

How does the EU exercise this influence?

Being the worlds leading trading power and therefore playing a decision role in international
negotiations
The EU takes a clear position on sensitive issues affecting ordinary people (environmental sustainability,
food safety, ethical aspects of biotechnology etc.
The EU remains at the forefront of global efforts to tackle global warming.

Values
The EU wishes to promote humanitarian and progressive values, and ensure that humankind is the beneficiary,
rather than the victim.
Europeans cherish their values, such as a belief in human rights, social solidarity, free enterprises, voting rights,
economic growth etc.
All EU countries have abolished the death penalty.

Chapter 5 What does the EU do?

The EU acts in a wide range of policy areas where its action is beneficial to the member states
o These includes:
Innovation policies, which bring state-of-the-art technologies to fields such as
environmental protection, research and development (R&D) and energy
Solidarity policies (also known as cohesion policies) in regional, agricultural and social
affairs
The Union funds these policies through an annual budget which enables it to complement and add value
to action taken by national governments. The EU budget is small by comparison with the collection
wealth of its member states: it represents no more than 1.23% of their combined gross national income.

Innovation Policies
The European Unions activities are: environmental protection, health, technology innovation, energy etc.

a. The environment and sustainable development

The EU aims to help prevent climate change by seriously reducing its greenhouse gas emission. All parties accepted
the need to limit global warming to an average increase of 2*C above pre-industrial levels, but no collective
commitment on achieving this goal exists. Developing countries will provide 20 billion to finance developing
countries action on climate change (as well as tackling noise, waste, protection of natural habits, exhaust gases,
chemicals etc).

b. Technological innovation
Europes future prosperity depends on its ability to remain a world leader in technology, by the European research.
Joint research at EU level is designed to complement national research programs, such as in controlled
thermonuclear fusion source of energy, and research and technological development.
50 billion + is being spent on research areas like health, food and agriculture, transport, security and space
etc.

c. Energy
One reason to reduce / rethink its energy production and consumption is the increasing imports of fossil fuels.
Another one is the process of global warming.
Energy E&D in Europe focuses on solar, wind, biomass and nuclear power (Clean sky project).

Solidarity policies
The purpose of these policies is to ensure the single market works properly, correcting imbalances in this market.
 a. Regional aid
European Union funds are used to boost development in regions lagging behind, to rejuvenate industrial areas in
decline, help young people etc.
The funds are earmarked for regional aid in 2007-2013 are targeted at three objectives
Structural fund Stimulates investment by the private sector and by national and regional governments.
Convergence: Helping the least-developed countries and regions by improving conditions for growth and
employment.
Regional competitiveness and employment: Increase competitiveness, employment levels and
attractiveness of regions.
European territorial cooperation: Increase cross-border, transnational in interregional cooperation, helping
neighboring authorities find joint solutions to shared problems etc.

Cohesion fund Used to transport infrastructure and environmental projects in EU countries, whose GDP per capita
is lower than 90% of the EU average.
European Regional Development Fund: Finance regional development projects and boost economy.
European Social Fund: Finance vocational training and help people find work.

b. The common agriculture policy (CAP) and common fisheries policy (DFP)
Aims of CAP:
Ensure a fair standard of living for farmers
to stabilize markets
to ensure that supplies reach consumers at reasonable price
To modernize farming infrastructure
The EU wants the WTO to put more emphasis on food quality, the precautionary principle (better safe than sorry)
and animal welfare.

c. The social dimension

Its aim is to correct the most glaring inequalities in European society. The European Social Fund (ESF) was
established in 2961 to promote job creation and the movement of them.
Furthermore, it established rights, e.g. the right of women and men to equal pay to equal work, or protection of
workers, and safety standards.
The Charter of Basic Social Rights (1997), sets out the rights that all workers in the EU should enjoy: free movement,
fair pay, improved working conditions, social protection, equal treatment of men and women etc.

Paying for Europe: The EU Budget

Budget plan of 140 billion in 2010 (1.23% of the total gross national income of all the member states), drawn by the
European Commission.
These resources are mainly drawn from:
Customs duties on products imported into the EU, including farm levies
% of the value added tax (VAT) levied on goods and services throughout the EU
Contributions from the member states, reflecting the wealth of each country
How the money is spent:
Chapter 6 The insight market

The single market is one of the EUs grates achievements. Restrictions on trade and free competition
between member countries have gradually been eliminated, this helping standards to living to rise.
The single market has not yet become a single economy: some sectors (services of general interest) are still
subject to national laws. Freedom to provide services is beneficial, as it stimulates economic activities
The financial crisis in 2008-2009 has led the EU to tighten up its financial legislation.
Over the years the EU has introduced a number of policies (on transport, competition, etc.) to help ensure
that as many businesses and consumers as possible benefit from the opening up the single market.

Achieving the 1993 objective

a. The limits of the common market
The 1957 Treaty established the European Economic Community (EEC) made it possible to abolish customs barriers
between the member countries and to apply a common customs tariff to goods from non-EEC countries (Reached in
1968).
In 1970, other trade barriers, such as technical norms, health and safety standards, exchange control etc. arose.

b. The 1993 objective

The aim was to stimulate the growth of trade and industrial activity within the single market a large unified
economic area on a par with the United States.
In 2987, the Single European Act was established and its provisions included:
Extending the powers of the EEC in some policy areas (social policy, research etc)
Establishing the single market by the end of 1992
Making more frequent use of majority voting in the Council of Ministers, to make it easier to take decision
about the single market

Progress on building the single market

a. Physical barriers
In 1985, 5 of the 10 member states signed the Schengen Agreement under which their national police forces
undertook to work together, and a common asylum and visa policy was set up Checks on persons at the borders
between the Schengen countries were abolished.

Today, 25 EU countries signed the Schengen Agreement, including three (Iceland, Norway & Switzerland) which are
not members of the EU.

b. Technical barriers
EU countries have agreed to recognize one anothers rules on the sale of most goods. Where services are concerned,
EU countries mutually recognize or coordinate their national rules allowing people to practice professions such as
law, medicine, tourism, banking or insurance.

c. Tax barriers
Tax barriers have been reduced by partially aligning national VAT rates.

d. Public contracts
Regardless of who awards them, contracts in any EU country are now open for bidders from anywhere in the EU.
Opening up national markets for services has brought down the price of national telephone calls to a fraction
of what they were 10 years ago.

Working in progress
a. Financial services
After the recession in 2008, the members of G-20 committed themselves to reforming the financial system so as to
make it more transparent and accountable. Europe-wide supervisory authorities exist.
 b. Piracy and counterfeiting
EU products need protection from piracy and counterfeiting.

Policies underpinning the single market

a. Transport
The EUs activities have focused mainly on ensuring the freedom to provide services in land transport, giving
transport companies free access to the international transport market and allowing transport firms from any EU
country to operate in all other EU countries.
All EU airlines may operate air services on any route within the EU and set fares at any level they choose many
new routes have been opened up and prices have fallen dramatically.

b. Competition
Competition is not only free but also fair, implemented by the European Commission and the court of justice.
Purpose: to prevent any business cartel, any aid from public authorities or any unfair monopoly from
distorting free competition within the single market.
Notification of any mergers and take-overs to prevent a company having a dominant position in a particular
market. (what does companies want: broad of narrow definition of markets? Broad: eg. takeovers in the
market of beverages makes it less easy to accuse of building a cartel; as compared to narrowly defined
market, eg. cola market)

c. Protecting consumers and public health

EU legislation in this field aims to give all consumers the same degree of financial and health protection, regardless
of where in the European Union they live, travel or do their shopping.
The EU also takes action to protect consumers from false and misleading advertising, defecting products and abuses
in areas such as consumer credit and mail-order or Internet selling.

Chapter 38 Common currency areas and European monetary union

Countries joined the European Economic and Monetary Union (EMU) in order to get the common currency, euro.
Common currency area (Currency union or monetary union): A geographical area throughout which a single
currency circulates as the medium of exchange.

The EURO
In order to participate in the new currency, member states had to meet strict criteria such as government budget
deficit or less than 3% of GDP, a government debt-to-GDP ratio of less than 60%, combined with low inflation and
interest rates close to the EU average.
THE European Central Bank (ECB), together with the national central banks of the countries making up the common
currency area, the European System of Central Banks (ESCB).
1 January 2002, the first euro notes and coins came into circulation as the single medium of exchange. There was a
belief that having a common European Currency would help complete the market for European goods, services and
factors of production that had been an ongoing project for much of the post-war period.

The single European market and the euro

Some of the major countries (Germany and France), expressed a desire to make further wars impossible between
them through a process of strong economic integration that would lead to greater social and political harmony
The European Union: A family of democratic European countries, committed to working together for peace and
prosperity.
Belgium, Germany, France, Italy, Luxembourg and the Netherlands first joined in 1973. The aim was to provide
businesses with an environment of fair competition in which economies of scale could be reaped and a strong
consumer base developed from which they could expand into global markets. Single European Market: a EU-wide
market throughout which labor, capital, goods and services can more freely.
Nevertheless, even through internal tariffs and quotas had been abolished in the EU, local tax systems and technical
regulations on goods and services still differed from country to country so that it was in practice often difficult to
export from one country to another.
Therefore, the European Act of Parliament was established in order to achieve four goals:
1. Free movement of goods, services, labor and capital between EU member states.
2. Approximation of relevant laws, regulation and administrative provisions between member states.
3. A common, EU-wide competition policy, administered by the European Commission.
4. A system of common external tariffs implemented against countries who are not members of the EU.

The Benefits and costs of a common currency

Benefits of a single currency
Elimination of transaction costs
It makes trade easier between members, and transaction costs were reduced. Importers no longer have to pay a
charge to a bank for converting their currency to the one of the other country.

Reduction in price discrimination

If goods are priced in a single currency it should be much harder to disguise price differences across countries.
Transparent markets and prices exist.

Reduction in Foreign Exchange rate variability

When a German supermarket imported wine from France to be delivered, say, three months later, it has to worry
about how much a French franc would be worth in terms of German marks in three months time and therefore
what the total cost of the wine would be in marks. This all changed, because of a common currency.
The reduction in uncertainty arising from the removal of exchange rate fluctuations may also affect investment in
the economy the future is less risky.

Lower borrowing costs due to more efficient markets

Lower admin. Costs (and less production costs can kick off demand)

NOTE: The benefits are more realized if there is a high degree of trade integration.

Costs of a single currency

The major cost to an economy in joining a common currency area relates to the fact that it gives up its
national currency and thereby gives up its freedom to set its own monetary policy and the possibility of
 macroeconomic adjustment coming about through movements in the external value of its currency. Now,
the ECB regulates everything.
o Suppose, there is a shift in consumer preferences across the common currency area away from wine
produced in Germany and towards wine produced in France. This leads to a leftward shift in the
German short-run aggregate demand curve and a rightward shift in the French short-term aggregate
demand curve (Figure 38.1, Page 847). As unemployment rises in Germany, wages begin to fall.
Lower wages reduce firms costs and so, the amount supplied will be higher the German short-
run aggregate supply curve shifts to the right.

o German goods become less expensive to French residents. Therefore, French net exports would fall,
leading to a fall in aggregate demand (Figure 38.2, page 848).

o The ECB will not be able to keep both countries happy. Most likely, it will set interest rates higher
than the German desired level and lower than the French desired level.

No national exchange rate instrument to kick start growth (via exports) or reduce economic shocks

Loss of sovereignty and democratic deficit

The theory of optimum currency areas
Optimum currency area (OCA): A group of countries for which it is optimal to adopt a common currency and form a
currency union, one of the final stages in economic integration.
Since there is no way for certain of ensuring whether it is indeed optimal for a group of countries to form a currency
union, there are criteria to join, but they are used loosely.

Characteristics that reduce the costs of a single currency

1. Wage flexibility within the group of countries
a. The real wage is of importance here: it is real wages that must adjust in order to affect the aggregate
supply curve by making it more (or less) profitable for firms to produce a given level of output at any
given level of prices.
2. A high degree of labor mobility
a. Unemployed workers just cross the border to get a job in another country.
3. A high degree of capital mobility
a. Physical capital can help by expanding productive capacity in countries experiencing a boom as firms
in other member countries build factories there.
b. The mobility of financial capital may be more useful, resident of a country experiencing a recession
may wish to borrow money from the residents of a country experiencing a boom in order to
overcome their short-term difficulties.
4. Systematic Macroeconomic shocks
a. Economies tend to enter recession at the same time and enter the recovery phase of the cycle at the
same time, so that disagreements about the best interest rate policy are less likely to occur.

Assume: Economic shock, Asymmetric shock

Depends on degree of integration and similarity structure
Case of asymmetric shock: One of the countries on the monetary union exports mainly agricultural products
while the others export manufactured goods. If there is a drought in all countries, it will only slightly reduce
the net exports of only one country.

Assume: Economic shock, Symmetric shock

Depends on degree of integration and similarity structure
Case of symmetric shock: Automotive sector on the Eurozone; suppose of the countries were hot with
symmetric shock: all automotive sectors in Eurozone face higher energy costs for production and assembling
cars. Risk of reduction in the net exports of all Eurozone countries.
What policies available?
Symmetric shock:
o Change exchange rates / interest rates (EU < -- > US)
Asymmetric shock:
o One size fits all?
o What other policies are available?
Decrease prices wages
Move labor
Transfer capital
Increase efficiency, productivity
What does the theory say about loss of exchange rate policy?
Importance of advantages relative to disadvantages depends on:
Level of integration + similarity of economic structure
Flexibility (labor) markets
o Physical mobility
o Wage mobility