Economic readings summary:

Chapter 12

Macroeconomics: the big picture

Readings:
Microeconomics, which is concerned with the consumption and production decisions of
individual consumers and producers and with the allocation of scarce resources among
industries, was already a well-developed branch of economics.

Macroeconomics: which focuses on the behavior of the economy and a whole, was still in its
infancy. Examines the overall behavior of the economy, how the actions of all the individuals
and firms in the economy interact to produce a particular economy-wide level of economic
performance.
 Long run economic growth
 Inflation
 International macroeconomics

What is the difference between macro and micro?

What are business cycles and why do policy makers try to diminish their severity?
How does long-run economic growth determine a country’s standard of living?
What are inflation and deflation, and why is price stability preferred?
Why does international macroeconomics matter, and how do economies interact through
trade deficits and trade surpluses?

Before 1930s -> economist thought of the economy as self-regulating, they thought that
problems such as unemployment would be solved by the working of the invisible hand and
government interference would only cause more problems.

Keynesian economics, a depressed economy is the result of inadequate spending. In

addition, Keynes argued that government intervention can help a depressed economy
through monetary policy and fiscal policy.

Monetary policy uses changes in the quantity of money to alter interest rates, which affect
the level of overall spending.
Fiscal policy uses changes in taxes and government spending to affect overall spending.

Before the 1930s, economist tended to regard the economy as self-regulating. After the
great depression, Keynesian economics provided the rationale for government intervention
through monetary policy and fiscal policy to help a depressed economy.

Recessions, or contractions, are periods of economic downturn when output and

employment are falling.

Expansions, or recoveries, are periods of economic upturn when output and employment
are rising,
Understanding 12-1
 a. Jj
b. Macro->
c. Macro-> it is about a whole generation and standard of living is not something within
one company, but within the whole marker.
d. Micro-> it is about salaries for students which is individual and about the
consequences decisions have made.
e. Micro-> it is about overall economics.
f. Macro
g. Macro

2. consequence for lacking of credit, when people cannot get credit to finance their
purchases, they will be unable to spend money. This will weaken the economy, and as
others see the economy weaken, they will also cut back on their spending in order to save
for future bas times. As a result, the credit shortfall will spark a compounding effect through
the economy as people cut back their spending, making the economy worse, leading to
more cutbacks in spending, and so on.

The business cycle

The business cycle is the short-run alternation between recessions and expansions

The point at which the economy turns from expansion to recession is a business-cycle peak.

The point at which the economy turns from recession to expansion in a business-cycle
trough.

low unemployment rate jobs easy to find

high unemployment rate jobs are scarce

effect on the ability of workers to find and hold jobs. The most widely used indicator of
conditions in the labor market is the unemployment rate.

Modern macroeconomic largely came into being response to the worst recession in history.

We talk about business cycles for the economy as a whole because recessions and
expansions are not confined to a few industries -> they reflect downturns and upturns for
the economy as a whole. In downturns, almost every sector of the economy reduces output
and the number of people employed. Moreover, business cycles are an international
phenomenon, sometimes moving in rough synchrony across countries.

A recession has a lot of casualties, they cause large numbers of workers to lose their jobs
and make it hard to find new jobs. Recessions hurt the standard of living of many families
and are usually associated with a rise in the number of people living below the poverty line,
an increase in the number of people who lose their houses, because they cannot afford their
mortgages payments, and a fall in the percentage of Americans with health insurance.
Recessions also hurt the profits of firms.
America has long-run economic growth, the sustained rise in the quantity of goods and
services the economy produces. This sustained rise, in turn, reflects one of our basic
principles of economics. Increasing in the economy’s potential lead to economic growth
over time. Dwarfing the ups and downs of the business cycle.

1. Long run economic growth is a modern intervention-> growth began in 1890

2. Countries do not necessarily grow at the same rate.

A major concern of macroeconomics, trying to understand the forces behind long-run

growth.
Long-run growth is an even more urgent concern in poorer, less developed countries.

Argentina and Canada first had the same economic growth and system, namely major
exporters of agricultural product, both attracted large numbers of European immigrants;
both also attracted large amounts of European investment -> railroads that opened their
agricultural hinterlands.

Countries with high rates of population growth will have to maintain higher long-run growth
rates of overall output than countries with low rates of population growth in order to
achieve an increased standard of living per person, because aggregate output will have to be
divided among a larger number of people.

The point is that between 1980 and 2020 the economy experienced substantial inflation: a
rise in the overall level of prices. Understanding the causes of inflation and its opposite,
deflation – a fall in the overall level of prices – is another main concern of macroeconomics.

Causes inflation and deflation: it is not only cause by supply and demand, but movements in
inflation are also closely related to the business cycle. When economy is depressed and jobs
are hard to find inflation tends to fall; when the economy is booming, inflation tends to rise.

In long term inflation is determined by changes in the money supply, the total quantity of
assets that van be readily used to make purchases. Hyperinflation, in which prices rise by
thousands or hundreds of thousands of percent, invariably occurs when governments print
money to pay a large part of their bills.

Problems:
- Inflation discourages people from holding onto cash, because cash loses its value
over time if the overall price level is rising.
- Deflation, if the price level is falling, cash gains value over time, the amount of goods
and services you can buy with a given amount of cash increases. Holding on to cash
is more attractive than investing in new factories and other productive assets
-

Price stability -> which overall level of prices is changing only slowly as a desirable goal.

International imbalances
The united states is an open economy:
An economy that trades goods and services with other countries.

2018 us ran a big trade deficit-> that is the value of the goods and services U.S. producers
sold to customers abroad.
Trade surplus: a country has a trade surplus when the value of the goods and services it
buys from the rest of the world is smaller when the value of the goods and services it sells
abroad.

There is no simple relationship between the success of an economy and whether it runs
trade surpluses or trade deficits.

International trade is the result of comparative advantage -> countries export goods that
they are relatively good at producing and import goods they are not good at in production.
 It cannot explain why a country exports some goods and services and exports these.

The determinants of the overall balance between exports and imports lie in decisions about
savings and investment spending – spending on goods like machinery and factories that are
in turn used to produce goods and services for customers. Countries with high investment
spending relative to savings run trade deficits; countries with low investment spending
relative to saving run trade surplus.

Chapter 13:

Gross domestic product ->

National accounts/product accounts

 Keeps track of spending of consumers, the sales of producers, business investment
spending, government purchases, and a variety of other flows of money between
different sectors of the economy.

1. Government purchases of goods and services

 Government buy things for its own use and transfer payments
2. Consumer spending
 Purchasing goods and services through markets for goods and services from firms or
imports from the rest of the world.
3. Firms, firms buy goods and services from each other when they engage in
investment spending, spending on productive capital
4. Exports
 goods and services sold to residents of other countries

goods and services that are purchased by households , governments, or firms, but produced
by residents of another country, are known as imports.

Consumer spending + investment spending+ government purchases of goods and services +

value of exports – the value of import)
Intermediate goods and services: goods and services that are inputs for production of final
goods and services.

Final goods and services:

Are goods and services sold to the final, or end, user.

Another way of calculating GDP

1. total spending on final goods and services

the total flow of funds into the markets for goods and services – the sum of consumer
spending, investment spending, government purchases of goods and services and exports
minus import.

The third way of calculating GDP = total income earned in the economy. Firms and the
factors of production that they employ, are owned by households. Money into firms from
the markets for goods and services. -> this it the total value of production.

Why is GDP equal to the total value of factor income paid by firms in the economy to
households? Because each sale in the economy must accrue to someone as income – either
as wages, profit, interest or rent. To sum the total factor income earned by households from
firms in the economy.

1. Survey and add up total value of all final goods and services produced.
2. Add up aggregate spending on all domestically produced goods and services in the
economy.
3. Add up the total factor income earned by households from firms in the economy.

Government statisticians use all three methods.

Measuring GDP as the value of production of final goods and services.

Measuring GDP as spending on Domestically Produced Final Goods and Services
Measuring GDP as factor Income earned from firms in the Economy

Aggregate output is the economy’s total quantity of output of final goods and services.
The components of the GDP

GDP -> tells us?

 The size of a economy, it can compare the economies of different nations
 But we need to be careful to approach this matter with this measurement, because
part of the increase in the value of the GDP over time represents increases in the
prices of goods and services rather than an increase in output.
 Modified GDP is needed to understand the real economic change
Real GDP -> inflation is calculated within this measure
Is the total value of all final goods and services produced in the economy during a given
year, calculated using the prices of a selected base year.
Nominal GDP:
Is the value of all final goods and services produced in the economy during a given year,
calculated using the prices current in the year in which the output is produced.

Real GDP
The measure that is used for this purpose is known as real GDP. By tracking real GDP over
time, we avoid the problem of changes in prices distorting the value of changes in
production of goods and services over time.

As a result, us statistics on real GDP are always expressed in chained dollars.

A country with a larger population will have higher GDP simply because there are more
people working.

GDP per capita -> GDP divided by the size of the population, equivalent to the average GDP
per person. -> comparison of labour productivity between countries.

Other limitations:
- Measure of a country’s living standard
- Not a match with gdp and quality of live

Price indexes and the aggregate price level

Single number representing the overall level of output, they also find it usefull to have a
single number representing the overall level of prices : the aggregate price level.

Answer question in three ways:

- How much has the price increased?

The overall measure -> the average price change

 To measure the average price changes for consumers goods and services,
economists track changes in the cost of a typical consumer’s consumption bundle.
The typical basket of goods purchased before the price changes.

Market basket-> is used to measure changes in the overall price level, known as a market
basket.

A price index measures the cost of purchasing a given market basket in a given year, were
that cost is normalized so that it is equal to 100 in the selected base year.

The inflation rate is the percent change per year in a price index- typically the consumer
price index.
The consumer price index, or CPI, measures the cost of the market basket of a typical urban
American family.

Price index in a given year= cost of market basket in a given year/ cost of market basket in
base year x 100

Inflation rate = price index in year 2 – price index in year 1 / price index in year 1 x 100

The consumer price index

 To show how the cost of all purchases by a typical urban family has changed over
time.

Other price measures:

Producer price index
 Measures the cost of a typical basket of goods and services – containing raw
commodities such as steel, electricity, coal and so on -> purchased by producers.

Chapter 14:
Unemployment and inflation

High unemployment incurs humand and economic waste because willing wotkers can’t find
jobs.
High inflation undermines the monetary system through rapidly rising prices.
 Two goals are low unemployment and price stability, usually defined as a low but
positive rate of inflation.

Europe 2011 -> unemployment was still high in aftermath of the 2008 financial crisis, but
inflation had also accelerated sharply.
 ECB under the rule by France’s Jean-Claude Trichet, decided that threat of inflation
was greater than the threat of unemployment. So they raised rates, the rise of
inflation reflected temporary factors, but unemployment continued to rise.

Defining and measuring unemployment

Retired people are not unemployed and disabled persons are not unemployed.

A countries labor force = is the sum of employment and unemployment – that is, of people
who are currently working and people who are currently looking for work, respectively.
The labor force participation rate, defined as the percentage of the working-age population
that is in labor force, is calculated:

Labor force participation rate = labor force/ population age 16 old and older x 100

Unemployment rate= number of unemployed workers/ labor force x 100

Is calculated with the current population survey-> working or not-> how long searching for a
job.
The significance of the unemployment rate
Quit rate -> the fraction of workers voluntarily leaving their jobs in any given month.

Unemployment rate is a good indicator of the current labor market.

But it is not a liberal measure of the percentage of people who want a job but can not find
one.

The reasons that measured unemployment persists even when jobs are abundant.
 A worker whi is quit confident of finding a job, but just has not accepted one.

Discouraged workers, the measured unemployment rate understate the percentage of

people who want to work but are unable to find a job.

Marginally attached workers-> are people who would like to have a job and have looked for
work in the recent past but are not currently looking for work, not included in the
unemployment rate.

underemployed: workers who would like to find full-time jobs but are currently working
parttime ‘’ for economic reasons’’ -> also not counted in the unemployment rate.

The bureau of labor statistics is the federal agency that calculates the official unemployment
rate.
 It also calculates broader ‘’measures of labor underutilization.

So even at times when the overall unemployment rate is relatively low, jobs are hard to find
for some groups.

Growth and unemployment

Causes of unemployment:
 Recessions
 Pandemic

Although the economy was growing, it was not growing fast enough to reduce the
unemployment rate.

A period in which real GDP is growing at a below-average rate and unemployment is rising is
called a jobless recovery or a growth recession, it typically follows a deep recession.

The natural rate of unemployment

Job creation and job destruction

Job separations -> terminations of employment that occur because a worker is either fired
or quits voluntarily.

Reasons jobloss:
Structural change in economy: industries rise and fall as new technologies emerge and
consumers tastes changes, but it can also brings creation of new jobs.

There are two types of unemployment:

1. Frictional
2. Structural

Frictional:
Is unemployment due to the time workers spend in job search. Who have not yet found
their next job. The economy is more productive if workers take the time to find jobs that are
well matched to their skills, and workers who are unemployed for a brief period while
searching for the right job do not experience great hardship.

It jumped to 45% after the great recession but came gradually down as the economy
recovered.

Structural unemployment
Sometimes there is a persistent surplus of job seekers in a particular labor market, even
when the economy is at the peak of the business cycle.

Structural-> is unemployment that results when there are more people seeking in jobs in a
particular labor market than there are jobs available at the current wage rate.
 Economist look at the level of unemployment at the peak of the business cycle

The price of labor- the wage rate increases, employers demand less labor.

The upward-sloping labor supply curve indicates that when the price of labor increases,
more workers are willing to supply labor at the prevailing wage rate.

Even at the equilibrium wage rate we ther will still be some frictional unemploymeny. That
is because there will always be some workers engaged in job search even when the number
of jobs available is equal to the number of workers seeking jobs. But there would not be any
structural unemployment in this labor market.

Structural unemployment occurs when the wage rate is, for some reason, most important
being minimum wages, unions, efficiency wages, the side effects of government policies,
and mismatches between employees and employers.

More people want to work than can find jobs at the minimum wages – that is, binding
minimum wages – can lead to structural unemployment.

Most economist, however, agree that a sufficiently high minimum wages does lead to
structural unemployment.

Unions
 Organizations of workers that bargain collectively with employers to raise wages and
improve living standards of their members, can have effects similar to those of minimum
wages.

Unions can achieve higher wages-> collective bargaining

Labor strike-> collective refusal to work

Lockouts-> periods in which union workers are locked out and rendered unemployed. While
hiring replacement workers.

Union also bargains over health care and pensions, which we can think of as additional
wages.

The result of these increased wages can be the same as the result of a minimum wage: labor
unions push the wage that workers receive above the equilibrium wage.

Side effects of government policies-> structural unemployment-> this generosity reduces a

workers incentive to quickly find a new job.

Efficiency wages-> wages that employers set above the equilibrium wage rate as an
incentive for their workers to perform better.
Actions by firms can be contribute to structural unemployment.

Mismatches between Employees and employers

 More jobs less people to do it
 Less jobs more people want it

The natural rate of unemployment

 Is the normal unemployment fluctuating around this normal level, is the normal
unemployment rate around which the actual unemployment rate fluctuates.
 It is the rate of unemployment that arises from the effects of frictional plus structural
unemployment.

Cyclical unemployment
Is the deviation of the actual rate of unemployment from the natural rate; that is, it is the
difference between the actual and natural rates of unemployment.

Natural unemployment = frictional unemployment + structural unemployment

Actual unemployment = natural unemployment + cyclical unemployment

1. The natural rate of unemployment changes over time

2. It can be affected by government policies

Changes:
The most important factors are changes in labor force characteristics, changes in labor
market institutions, and changes in government policies.
Example characteristics change-> baby boom + rising percentage of women
 Percentage labor force women grew rapidly
 But after that it decreased

Changes in labor market institutions

Technological change, coupled with labour marker institutions can also effect the rate
 Techn -> tends to increase demand for skilled worker and reduce demand unskilled
worker

Changes in government policies

Example: job training and employment subsidies
Job-training programs= are supposed to provide unemployed workers with skills that widen
the range of jobs they can perform
Employment subsidies are payments either to workers or to employers that provide a
financial incentive to accept or offer jobs.

Software improvements developed by employment websites that enable jobseekers to find

more jobs more quickly will reduce the unemployment rate over time. However, websites
that induce discouraged workers to begin actively looking for work again will lead to an
increase in the unemployment rate over time.

When the pace of technological advancement quickens, there will be higher rates of job
creation and destruction as old industries disappear and new ones emerge. As a result,
frictional unemployment will be higher a workers leave jobs in declining industries in search
of jobs in expanding industries.
When the pace of technological advancement quickens, there will be greater mismatch
between the skills employees have and the skills employers are looking for, leading to
higher structural unemployment.

When the unemployment rate is low, frictional unemployment will account for a larger
share of total unemployment because other sources of unemployment will be diminished.
So, the share of total unemployment composed of the frictionally unemployed will rise.

A binding minimum wage represents a price floor below which wages cannot fall. As a
result, actual wages cannot move toward equilibrium. So, a minimum wage causes the
quantity of labor supplied to exceed the quantity of labor demand. Because this surplus of
labor reflects unemployed workers, It affects the unemployment rate.

Inflation and deflation

Workers real wage-> the wage rate divided by the price level
Real incomes-> incomes divided by the price level
Level of prices does not matter; the rise in prices in the us economy over the past 50 years
has not made us any poorer.

But the rate of change of prices does

Inflation rate-> the percent increase in the overall level of prices per year. Recall from ch 13
that the inflation is defined as follows:

Inflation rate = price index year 2- price index in year 1 / price index in year 1 x 100

Shoe leather costs-> cash in their wallets and bank deposits for convenience in making
transactions.
Higher inflation discourages people from holding money because the purchasing power of
the cash in your wallet and the funds in your bank account steadily erode as the overall level
of prices.

Shoe-leatyher costs-> an allusion to the wear and tear caused by the extra running around
that takes place when people are trying to avoid holding money.

Menu costs
 In a modern economy, most of the things we buy have a listed price. Changing a
listed price gas a real cost, called a menu cost,

Unit of account costs

 Renters own a certain numbers of dollars per month, a company that issued a bond
promises to pay the bondholder the dollar value of the bond when it comes due, and
so on.

Economic calculations:
Family planning its budget, small firm figures out how they are doing, estimates money that
goes in or out.

Unit of account-> role of the dollar as a basis for contracts and calculation.
The unit-of-account costs of inflation are the costs arising from the way inflation makes
money a less reliable unit of measurements.

Winners and losers from inflation

 That economic transactions often involve contracts that extend over a period, such
as loans, and these loans-> nominal

Interest rate: is the return a lender receives for allowing borrowers the use of their savings
for one year, calculated as a percentage of the amount borrowed.

Nominal interest rate-> is the interest rate in dollar terms

Real interest rate-> is the nominal interest rate minus the rate of inflation
If the actual inflation rate is higher than expected, borrowers gain at the expense of lenders:
borrowers will repay their loans with funds that have a lower real value than had been
expected.
If the inflation is lower than expected, pay with higher value than before.

People do not get a long-term contract because of the uncertainties with inflation.
Unexpected deflation -> a surprise fall in the price level – creates winners and losers too.
Disinflation-> is very difficult and costly once a higher rate of inflation has become well
established in the economy.

According to many economists, these periods of high unemployment that temporarily

depressed the economy were necessary to reduce inflation that had become deeply
embedded in the economy.

 Inflation may be accelerating

Chapter 20:
Readings week 2:
Capital flows and the balance of payments
Economist keep track of international transactions using different but related set of
numbers, the balance of payments accounts.

Balance of payments accounts

= a summary of the country’s transactions with other countries for a given year.

Factor income-> the income that foreigners paid to US residents for the use of American-
owned factors of productions, as well as income paid by the United States to foreigners for
the use of foreign-owned factors of production.
 Labor income is also included-> the wages of an American engineer who worked
temporarily in Dubai.

Transfers-> funds sent by American residents to residents of other countries and vice versa

Transaction that does not create liabilities are considered part of the balance of payments
on current account, often referred to simply as the current account.
 Which means the balance of payments on goods and services plus net international
transfer payments and factor income.
 Row 1,2,3
The balance of payments on goods and services, the difference between the value of
exports and the value of imports during a given period.

Merchandise trade balance

  It is the difference between a country’s exports and imports of goods not alone, not
including services.

Some economists -> focus on merchandise even though it is an incomplete measure,

because data in services are not as clear as data on trade with physical goods.

Balance of payments on financial account -> transaction that involve the sale or purchase
of assets, and therefore do create future liabilities-> capital account.

Current account deficit: the amount it paid to foreigners for goods etc, was more than they
have received.
 Transactions that do not create liabilities are considered part of the balance of
payments on current account

Financial account surplus

 the value of assets it sold to foreigners was more value of the assets it bought from
foreigners.

Current account (CA) + Financial account (FA) = 0

Or CA= -FA

Positive current account entries (lower blue arrow) + positive financial account entries =
(lower green arrow)

Negative current account entries + negative financial account entries

 Positive current account- negative current account + positive financial account –
negative financial account= 0

International differences in investment opportunities generate international differences in

the demand for capital.
A country with a rapidly growing economy, other things equal, will offer more investment
opportunities and a higher return to investors than a country with a slowly growing
economy.

Factor income: the income that foreigners paid to us residents for use of American owned
factors of production.

Mostly investment income: the interest that paid by Americans on loans from overseas
Transfers: skilled Americans who work abroad.

Balance of payments on good and services

 The difference between the value of exports and imports
Us current account deficit

These tax differences create an incentive for multinational corporations to report large
investments in low-tax countries
International differences in the supply in funds reflect differences in savings across the
countries.
 Result of private saving rates or government savings
 Government budget deficits -> reduce national savings-> can lead to capital inflows

Countries with a high demand for capital or a low supply of capital will have higher interest
rates. -> capitals inflows
Countries with a low demand for funds an or a high supply of funds will have lower interest
rates. -> capitals outflows

Two-way capital flows

Net capital flows
More motives for international capital flows besides seeking a higher rate of interest,
Individual investors often seek to diversify against the risk by buying stocks in several
countries. Us or eu investors try to reduce their risk, so they buy some us assets or eu
assets. -> two capital flows.

The role of the exchange rate

The behavior of the financial account reflecting inflows or outflows of capital is best
described by equilibrium in the global loanable funds markets.
Main part of the current account is determined by the decisions in the international markets
for goods and services.

 The exchange rate makes the financial and current account in balance.

The price is the exchange rate, which is determined in the foreign exchange market
= the price at which currencies trade.

When a currency becomes more valuable -> appreciates

When it becomes less valuable -> depreciates

Determination of exchange rates-> supply and demand in the foreign exchange market.

When a country appreciates exports falls and import rise.

When a country currency depreciates exports rises and imports falls.

If the dollar appreciate, things in America will be expensive, Europeans will buy less from the
us and will acquire fewer dollars in the foreign exchange market, us dollars demanded fall
and the demand of euros rises.

If the us dollars depreciates, American products become cheaper for Europe, eu buys more
from us, that acquires buying more dollars in the foreign exchange market, quantity of
dollar demand rises, as the number of euros needed to buy a us dollar falls and the us dollar
rises.

The equilibrium exchange rate is the exchange rate at which the quantity of us dollars
demanded in the foreign exchange market is equal to the quantity of U.S. dollars supplied.
The appreciation of the US dollar. A rise in the number of euros per US dollar leads
Americans to buy more European goods and services and Europeans to buy fewer American
goods and services.

Change in the preference of European investors. The demand for US dollars in the foreign
exchange market falls, and the dollar depreciates: the number of euros per US dollar at the
equilibrium exchange rate falls. This leads to Americans to buy fewer European products
and Europeans to buy more American products. Ultimately, this generates an increase in the
us balance of payments on current account. So a fall in capital flows into the united states
leads to a weaker dollar, which in turn generates an increase in US net exports.

Inflation and real exchange rates

 Exchange rates adjusted for international differences in aggregate price levels.

Real exchange rates: Mexican pesos per us dollar x Pus/Pmex

Nominal exchange rate-> the unadjusted exchange rate for aggregate price level -> nominal
exchange rate.

The purchasing power parity between two countries’ currencies is the nominal exchange
rate at which a given basket of goods and services would cost the same amount in each
country.

1000 pesos = 100 dollar

10 pesos per dollar

Chapter 15
Price stability
 Is the main task of the eurosystem -> treaty of Maastricht
At this juncture the governing council considers that price stability is best maintained by
aiming for a two per cent inflation target over the medium term.

Logic behind this price stability objective -> the monetary neutrality principle, in the long
run monetary policy only impacts inflation.

Monetary policy affects short term the economic growth rate, employment, and financial
conditions.

Central bank independence

In order to fulfil its primary task, a central bank must be free to operate without
interference.
Different parties as governments do not mindethe printing press, firms ask to lay of the
monetary policy so do the trade unions are afraid for employment. Debtors like inflation for
their debt to be less of value.
Inflation is painful for two reasons:
1. Inflation hurts some groups that are ill-equipped to respond to inflation, typically the
poor and ill-educated people.
2. The eventual elimination of inflation requires long periods of slow growth and high
unemployment that follow the tightening of monetary policy.
This is why price stability is necessary.

The fisher principle:

Nominal interst rate = real interest rate + expected inflation.

Domestic inflation rate I = I’ foreign inflation rate + expected exchange rate depreciation.

Exchange rate depreciation = domestic inflation rate – foreign inflation rate

The central bank can be undermined on purpose or by accident when government runs
budget deficit, it borrows from financial markets. if the deficits are large enough for long
enough, the markets may eventually become concerned about the ability of governments to
serve their debts -> markets refuse to lend more money -> financial crisis-> government can
no longer operate-> exchange rate is plummet-> banking system under threat.

ECB either needs to create money to finance the deficit or the country experiences an acute
crisis.

To strive against this there is a fiscal discipline clause-> stability and growth pact.

The five entry conditions

Every country other interest rate, because they had an central bank of their own.
It was necessary that when the national exchange rates disappeared that every country
must remain competitive by holding on to the price stability objective.

Oca criteria -> competitiveness was essential to uphold and deepen the two oca criteria that
were best fulfilled.

Finally, a loss of competitiveness would lead to a fall in exports, which would be followed
irremediably by economic decline.
Two other criteria of the OCA
 Absent labor mobility
 Transfer system
Loss of competitiveness would result in severe hardship, which would challenge the very
existence of the common currency.

Five entry conditions for the monetary union would be required.

1. Inflation -> a country’s inflation rate should not exceed the average of the three
lowest inflation rates achieved by the EU member state by more than 1,5 percent.
 2. Long-term nominal interest rate, the long-term interest rate should not exceed the
average rates observed in the three lowest-inflation-rate countries by more than 2
percentage points.

3. Erm membership: a country must have demonstrated its ability to keep its exchange
rate tied to the currencies of its future monetary union parners long enough without
a devaluation. The requirement is that evry country must have taken part in the
exchange rate mechanism ERM for at least two years without having to devalue its
currency.

4. Fourth sets a limit on acceptable budget deficits, budget deficits are acceptable only
if they correspond to public investment spending (on roads, telecommunications and
other infrastructure). Hence the condition that budget deficits should not exceed 3
percent of GDP.

5. Public debt, each country should demonstrate a more stable feature of fiscal
discipline. The 60 percent debt limit can be seen as compatible with a deficit debt
ceiling of 3 per cent.

Two-speed Europe
An important aspect of the Maastricht treaty is that it introduced, for the first time,

The euro system:

The stopped short of merging the national central banks into a single institution, partly in
fear of having to dismiss thousands of employees and partly for political expediency.

The ECB 1998 coexists with national central banks, one which did not even exist prior to
1999 since Luxembourg, long part of monetary union with Belgium, established its own
central bank only to conform to the new arrangement.

The euro system

The European system of central banks (ESCB) is composed of the European central bank ECB
the national central banks (NCBs) of all EU member states.
The euro system implements the monetary policy of the Eurozone. If needed, it also
conducts foreign exchange operations, in agreement with the finance ministers of the
member countries. -> it holds an managed the official foreign exchange reserves of the
economic and monetary union member states.
 It is involved in the prudential supervision of credit institutions and the financial
system.

ECB is connected with the financial council, its president chairs the meetings, prepares and
implements decisions.
Provides instruction to the NCBs on how to carry out the common monetary policy.

Voting rights in the eurosystem

Governing council now has 25 members, each member had one voting, now it works on
rotation basis.

The five largest -> 4 votes

The remaining countries-> 11 votes

This is based on GDO and the size of its financial sector. One of the big four does not vote
and four of the other countries do not vote, with the rotation it is determined whether the
country votes or not in that meeting.

The policy objectives

Price stability
2 per cent inflation rate-> the euro system argues that this rate is goof trade-off between
the need to prevent citizens and firms from being concerned and the need for a buffer to
avoid falling into deflation, that is, below zero per cent. It also explains that the buffer is
needed given that inflation rates differ among member countries. Box. 15.5 examines the
euro system’s way of dealing with diversity.

Financial stability
When financial markets are unstable, banks and other financial institutions may suddenly
collapse.
 Budding financial crisis, central banks are expected to use their ability to create
money in no time in virtually unlimited amounts.
 Lending of last resort

Ecb as the single banking supervisor, along with the European banking authority. Micro
prudential and macroprudential, which are told to improve their ability to suffer losses
through various reserves.

Climate change
 To take into account potential disruptions provoked either by climate events or by
policies adopted to contain climate change.

Monetary policy instruments

EONIA
 European over night index average
This interest rate corresponds to lending and borrowing among banks from one evening to
the next morning on what is called the interbank market. EONIA is gradually being replaced
by STR-> euro short term rate

1. Facing the crisis, the eurosystem brought uts main refinancing rate to zero and the
deposit rate below zero – while temporarily changing its procedure, pressing the
EONIA rate towards the deposit rate as explained in ch 16.
2. Main refinancing operations, the eurosystem usually coducts weekly auctions at rate
that it chooses.
Read this chapter again 15.4.3

Non-standard instruments
When the short term rates are at the effective lower bound, central banks could try and
lower longer-term rates and thus encourage private spending, these rates however are set
in the financial markets were lenders and borrowers meet. The central bank -> to imagine
various ways of influencing medium- to long-term rates.

1. Quantitative easing -> is to swamp the financial markets with cash. The central
banks buy assets from banks and other financial institutions, which they pay for by
issuing cash. Market ends owning more cash than it wishes to hold.
2. Forward guidance-> another instrument is to make promises. Having reached the
effective lowe bound, many central banks announced their intentions of keeping the
short-term interest rates at or close to the lower bound for a very long period.
Announcements are meant to lower interest rates at all maturities.
It hopes to bring its policy rates back into positive territory but stands ready to use
the balance sheet and forward guidance instruments again in the event that it hits
the effective lower bound again.

Independence and accountability

Institutional arrangements
ECB and all NCBs are strictly protected from political influence.

Status of euro system officials

The personal independence of the ECB executive board member is guaranteed.
They are appointed for a long period and cannot be reappointed, which shields them from
pressure while in office.

NBCs office mandates must be for a minimum of five years and some may be reappointed.
No central bank official can be removed from office, only incapacitated or guilty of serious
misconduct.

Policy objectives and instruments

as long as it can relate to the actions to the objective of price stability, the eurosystem
decisions cannot be challenged.