Macroeconomics II Essay 2015

Due date: 14 September 2015

ECO2004s

Jenna Allenbrook

Economic recovery from the Global Financial crisis has been mixed across Europe, with
many countries still suffering from weak economic growth, high unemployment and large
financial problems. Few countries have been truly able to overcome the financial crisis. It is
important to note that when the debt crisis hit, the financial situation of no two European
countries were the same. It is therefore difficult to imagine a situation where one type of
fiscal policy would bring about the best results for each and every country in the EU. An
austerity fiscal policy may be the best result for countries such as Germany that had stronger
economies before the Debt Crisis hit, as opposed to countries that were already in debt such
as Greece for whom austerity has had adverse effects.

The IS-LM model was initially introduced by John Hicks in 1937 (Blanchard, O. 2011), and
rests on two fundamental assumptions. The first is that all prices, including wages are fixed,
and the second being that there exists excess production capacity in the economy. The model
is used to assess the impact of exogenous shocks on Interest rate and output levels, also
known as the endogenous variables of the model.

The Effectiveness of an Austerity Fiscal Policy

Germany is one country that has now implemented an austere fiscal policy in result to the
Global Financial Crisis and for them it has been very effective as they maintained a strong
economy, and have been ranked as the 3rd most competitive economy in Europe in 2015
according to The World Economic Forums Global Competitiveness Report (Drzeniek. 2015),
with a global rank of 5th. This report highlights the significant divide developing between
Northern Europe and the Southern, Central and Eastern countries in Europe, with North
Europe generally ranking much higher up on the competitiveness report.
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If we assume the economy was in equilibrium before the debt crisis, then its initial financial
position can be explained by the following IS-LM graph.
LM1

Interest rate i

C
B

IS1
IS2
YC YB

Output Y

YA

The impact of the global financial crisis was that Investment, Consumption and Total
Expenditure decreased. This resulted in the IS curve shifting leftwards from its initial position
at IS1 to IS2. Output and interest rates decreased. Equilibrium moves from A to B. If interest
rates remained unchanged then the economy would be at point C, and output would be
directly below point C.

An austere fiscal policy means cutting net government spending to balance the budget and
decrease the deficit. This is the opposite of an expansionary fiscal policy which would
involve spending more. Cutting government spending will work to counteract the effect of
automatic stabilizers on the economy however this only works effectively if we are assuming

the economy to be strong. If the economy is weak when the austerity fiscal policy is
implemented then the deficit could in fact rise.

The graph below shows the effect of an increase in taxes or a decrease in government
spending on the economy.
Interest
rate i
LM

iA
iB

IS1

IS2
YB

YA

Output Y

The result is a movement along the LM curve as the austerity fiscal policy causes a leftward
shift of IS1 to IS2. The decreasing interest rate sparks investment, as borrowing becomes
cheaper. This increase in investment is positive and should help to boost the economy and
lead to an increase in output in the future. The balancing of the government budget by
reducing the deficit also means that government debt payments are cheaper, and the
government will have more of the subsequent budget to spend on infrastructure, technology
and research and development, all of which will boost the economy further in the future, the
ideal result being a government budget surplus in future years such as in Germany in 2015.
This budget surplus is being pushed forward into 2016 to aid with the current refugee crisis
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that has hit Europe. While many countries are unable to afford the influx of foreigners across
their borders, countries with stronger economies such as Germany are in a financial position
to allow them access (Buergin. 2015). This extra spending in 2016 will then boost the
German GDP by 0.2 percent, according to Marcel Fratzscher, the head of the Economic
Institute (Buergin. 2015) if it were not for the austerity measures in place, this subsequent
spending would not have been possible and that extra growth would not be taking place.

Room for Monetary policy in The EU

Monetary policy can play a big part in aiding a countrys economy. In South Africa the mix of
expansionary monetary and fiscal policy meant that the economy was not hit too significantly
by the debt crisis. There is definitely room for Monetary Policy in the Euro zone, as the
European Central Bank

There is definitely room for Monetary Policy in Europe. The monetary policies of European
countries became unified upon entering the Euro zone, so we can accept that unless the
European central bank makes significant expansionary or recessionary policy changes, the
real interest rate of the countries will not be changed by monetary policy. Using Germany and
Greece as examples here, it is their significantly different fiscal policies as well as their
resources, technology, work ethic and attitudes of their peoples that caused the two
economies to react so differently to the debt crisis. Germany is strong in all of these areas,
leading the real interest rate in Germany to rise. This negatively affects Greece as capital
flows from the lower real interest rate country to the higher one. The monetary unification of
The EU does not allow for exchange rate adjustment, and so capital flows easily from Greece
to Germany. This effect multiples as the increasing prosperity of Germany attracts even more
capital to flow towards it and away from Greece. The Greek economy declines, and the
recession that follows causes an imbalance in its economy. The Greek government then issues
large amounts of bonds for debt financing in order to maintain its high domestic spending
levels. The overarching result is that the stronger countries get stronger while the weak
countries get weaker. Despite a lack of monetary policy involvement by the ECB at present,
money supply in Germany is increasing because of the unified currency and the interest rates
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in Germany being higher than those of Greece when the crisis began. This has the effect of an
expansionary monetary policy despite no conscious policy being enforced. An involvement
by the ECB would therefore prove positive for the Euro Zone, counteracting some of the less
attractive aspects of their unified currency.

When the interest rate falls below zero, people become indifferent between holding cash and
bonds. Money is being held just as a store of value. Changes in the Money Supply therefore
have no effect. This is known as the liquidity trap. A budget deficit will shift the IS curve
rightwards, which has no effect on the interest rate because of the horizontal LM curve. This
can be seen in the graph that follows (Krugman. 2011).
Interest rate i

LM

0
Full
Employme
nt
IS
Output Y

In the presence of a liquidity trap there is a limit to how much monetary policy can increase
the level of output. It may not be possible for monetary policy to increase output back to its
full employment level. The nominal interest rate is therefore zero, however what affects
spending is the real interest rate. With The Euro zone experiencing deflation (The
Economist. 2015) even a nominal interest rate equal to zero would mean a positive real
interest rate, which may still be too high to stimulate spending, and in the case of a liquidity
trap there is nothing that monetary policy can do about it. In countries experiencing a
liquidity trap at present there is therefore only so much that monetary policy can do to help
their economies, but overall the introduction of monetary policy will be positive for Europe
and will mean finding the ideal policy mix for the Euro zone.

Conclusion and Policy Recommendations

The ideal policy for the Euro zone is not one particular policy but rather different fiscal
policies relative to each country depending on its current economic state. There is definitely
room for monetary policy intervention by the ECB, which will mean a blanket policy due to
the united currency in place. Quantitative Easing is an example of this.
With regards to fiscal policy I believe the ideal to be austerity fiscal policy only in those
countries that have economies strong enough to withstand the increases in taxes and
decreases in government spending. For countries with weak economies an expansionary
fiscal policy is likely to be most effective, where the deficit may be increased in the short run
with the ultimate goal of decreasing it in the medium to long run. As stated by Larry Elliott,
economics editor of The Guardian, Isnt it the case that using Greece as a laboratory mouse
for an austerity experiment has been a failure? The answer is yes (Elliott. 2015).
The issue with this proposal is that some European countries such as Greece cannot afford to
make their debt payments at present so increasing their debt may seem foolish, which is why
intervention from the ECB is crucial, as well as continued financial support from other,
stronger economies in the Euro zone will be central to achieving the success of the Euro zone
as a whole. Another option would be for stronger Euro zone countries to simply write off the
Greek debt. Greece is a small country whose output accounts for less than 2% of the output of
the European Union (Elliott. 2015).
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A chain is only as strong as its weakest link, and for this reasoning it will be beneficial in the
long run for all countries within the Euro zone to commit to continuing their aid towards the
weaker countries involved, with the ultimate goal of the Euro zone up economy rising up in
its entirety.

The economies of countries in the Euro zone differ significantly, and one policy simply
cannot fit them all. The unionization of their currency means that monetary policy
intervention is limited and so fiscal policy is significantly relied upon to counteract the
automatic stabilizers at play. This makes it even more crucial that the correct policies are
adopted for each country within the Euro zone.

Referencing:

Blanchard, O, 2011. Macroeconomics Updated Edition. 5th ed. United States of

America: Pearson.
Margareta Drzeniek. 2015. Global Competitiveness Report. [ONLINE] Available
at:http://www.weforum.org/content/top-10-most-competitive-economies-europe-2.

[Accessed 12 September 15].

Rainer Buergin. 2015. Who's the Better Keynesian? Schaeuble Says He's the One..
[ONLINE] Available at: http://www.bloomberg.com/news/articles/2015-09-08/who-s-

the-better-keynesian-schaeuble-says-he-s-the-one. [Accessed 10 September 15]

Paul Krugman. 2011. IS-LMentary. [ONLINE] Available
at:http://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/?_r=2. [Accessed 10

September 15].
The Economist. 2015. The euro zone slides into deflation. The Good and the Bad.
[ONLINE] Available at:http://www.economist.com/blogs/freeexchange/2015/01/euro-

zone-slides-deflation. [Accessed 12 September 15].

Desai, Lord M, 2013. Austerity in the UK and the Eurozone: Kill or Cure?. A debate,

May 13, 1-4.

Larry Elliott, The Guardian. 2015. Greece's problems are the result of the eurozone
having no fiscal policy. [ONLINE] Available
at: http://www.theguardian.com/business/2015/feb/01/greece-problems-eurozonefiscal-policy-germany. [Accessed 10 September 15].