Unit 8 June 2005 Possible questions
1. Why is it thought necessary for members of the single currency to limit any budget deficit?
A government running a budget deficit is a Keynesian demand management tool used to stimulate an economy. Whilst for a single economy far from full employment these inflationary pressures are likely to be small, if many members of the EU persue this policy inflationary pressures will be created, as aggregate demand increases from AD1 to AD2 causing inflationary pressure of P1P2.
The Fiscal Growth and Stability Pact therefore agreed to limit all government deficits to less than 3% of GDP each year and 60% of GDP in total. Germany and France were very keen to curb the high borrowing of economies like Italy, though ironically it was German who exceeded these limits in 2003.
Inflationary pressures require a rise in interest rates to combat demand pull inflation, which is against the founding aims of the ECB of low interest rates and low inflation.
The existence of fiscal limits and a fixed monetary and exchange rate policy increases reliance of the government on supply side policies such as investment in health, education and infrastructure and decreasing trade union power to increase productivity and keep inflation low.
2. Explain how membership of the single currency reduces a country's economic sovereignty.
Economic sovereignty is the independence an economy has over its exchange rate, monetary, fiscal and supply side policies. Membership of the single currency means the economy loses all direct control of monetary variables—monetary policy and so exchange rate policy—and discretionary fiscal policy is strictly limited by the Stability and Growth Pact and convergence criteria.
The economy remains in control of automatic stabilisers (automatic fiscal policy) which automatically stimulates an economy during recession through benefits and—if used in conjunction with a progressive tax system—helps to dampen activity through income tax.
3. In connection with European Monetary Policy what is meant by “one size fits all”?
- One interest rate is set for the entire Eurozone.
- For this to “fit all” economies must have similar economic performance including converged business cycles.
- Asymmetric shocks cause problems for the one size fits all as by definition different economies react differently to the shocks (such as an increase in the price of oil).
4. How does a single current promote competition?
- Price transparency (where all consumers in the EZ can directly compare prices charged elsewhere in the EZ reduces price discrimination so increases both productive and allocative efficiency of firms.
- Removes the uncertainty about exchange rates so encourages investment within the EZ members so a firm can operate in a large stable market.
5. Why does the SEM create a need for regional policy?
- The SEM creates the free movement of labour and capital so causes migration of labour to more advanced areas, increasing the regional imbalance between areas of the SEM.
- Regional policy aims to increase incentives to invest in deprived and declining areas to correct the market failure of imbalance.