International Economics (Essay Sample)

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International Economics
Greece Bailout by the ECB
The sovereign debt crisis which rocked Europe in 2010 nearly led to the collapse of the Eurozone trading bloc and the abandonment of the Euro as the common currency. The major fear among the Eurozone countries was that the rise in debt levels of various member states coupled with high national deficits would lead to the downgrade of sovereign bonds by financial markets due to loss of confidence in the EU. Greece was among the foremost Eurozone countries which was in danger of defaulting on its debt and was the country which initiated the crisis. It was on the brink of insolvency due to unmanageable debt levels, declining tax revenues and also declining rates in the bond markets. The EU member nations instituted a series of bailout packages for the Greek economy to help it bounce back from the crisis. On May 1 2010, the Troika, made up of the EU, the IMF and the European Central Bank (ECB) agreed to provide a loan of €110 billion at a rate of 5.5 % to the Greek economy. The ECB guaranteed to accept both outstanding and new debt securities issued by the Greek government as collateral despite the country’s poor credit rating. The ECB’s solution was to set up the Securities Market Program (SMP) tasked with the purchase of public debt securities through the secondary markets of member states. The SMP was used as a monetary policy instrument for stabilizing the economy through the uniform transmission of monetary policy. The actions by the ECB constituted an expansionary monetary policy which involved an increase in money supply with a subsequent decrease in interest rates. It was expected to have varied effects on both price and output levels. The increase in money supply would increase money demand in excess of that needed for precautionary motives. Bonds would become more attractive which would lead to an increase in their prices and a fall in interest rates from I to I1 shown by a shift in the LM curve to the right as shown below


Figure  SEQ Figure \* ARABIC 1 SMP effects on the LM curve
The SMP program was meant to relieve market pressure as a result of sovereign debt risk by providing liquidity to various financial institutions The impending fear was that the use of the SMP would be inflationary to the Greek economy due to the rapid increase in money supply. However, the SMP program reduced the default risk through fiscal multipliers as a result of the ECB intervention. The program also facilitated increased bank credit to the economy and also improved the prices of government bonds.
Expected Outcome of the ECB bailout .The actions of the ECB were expected to lower the level of interest rates which would boost both consumption and investment in the economy. The fall of rates would lead to depreciation in currency due to capital outflows. Currency depreciation improves the current account in a country which increases the level of exports. The improvement in the current account would shift the AD curve to the right. This shift in the AD curve causes the price to increase from Pe to P1 and output from Yp to Y1.


Figure  SEQ Figure \* ARABIC 2 Expected outcomes on prices and output
Expansionary Fiscal policy and its Effects on Prices If the Greece government adopts an expansionary fiscal policy, there will be effects on both price and output levels. In an open economy, the expansionary policy would increase the aggregate demand in tandem with reduced taxes and increased government expenditure. An expansionary fiscal policy causes the aggregate demand curve to shift to the right from AD to AD1. The increase in aggregate demand would cause the output level to increase from Y to Y1 and the price to increase from P to P1 as shown below.


Figure  SEQ Figure \* ARABIC 3 Expansionary fiscal policy effects
The Greece bailout was not beneficial to the Eurozone as a whole. The bailout of the Greek economy inadvertently created a moral hazard and also increased the insolvency of the Greek economy. The decision to bail-out the Greek economy created a moral hazard through the communication of wrong signals to both lenders and governments of other member states. The bailout implied that should anything fail, the ECB and the IMF would always be there to support failing states. Additional loans to the Greece economy by the IMF and ECB also overburdened the Greek economy. This is because the economy was struggling to repay its original debts and an increase in loans only compounded the situation further.
Shortcomings of a Common Currency The euro was adopted as a single currency which would help in improving trade and finance between the 16-bloc Eurozone area. The Eurozone operates as a single market which facilitates the free transfer of goods, labor and capital and other services amongst member states. The adoption of the euro as the sole legal tender was meant to facilitate trade within the bloc with the assumption that the different member states had similar economic structures. However there are various shortcomings associated with the adoption of common currencies like the Euro. For example, negative economic signals emanating from one of the Eurozone countries will affect the bloc as a whole. The poor performance of individual member states could be potentially destabilizing to the trading bloc as a whole and could lead to the depreciation of the euro regardless of whether other member states are economically sound. A country operating under an independent currency can make relevant changes to its exchange rates to affect trade balances in its favor, for example, a country may devalue its currency to make exports more attractive to improve its current account. On the other hand, common currency blocs restrict exchange rate fluctuations in individual member countries. This may detrimental to member states who may want to devalue their currency to encourage exports or to boost tourism revenues. The only option available to them in this case would be to cut the costs of production which may involve such unpopular measures as cutting wages.
Quantitative Easing and its Effects on China Quantitative easing is a distinct form of monetary policy which involves the purchase of both long term and short term securities by the central bank. The purpose of this type of monetary policy is to lower interest rates and stimulate growth in the economy. The central bank lowers the interest rates of various securities such as corporate bonds and long-term treasury bills to levels which are lower than short-term treasury bills. In the aftermath of the 2008 financial crisis in the US, the Federal Reserve Bank increased the money supply in the economy through the purchase of treasury bonds. They continued this quantitative easing policy objective until real interest rates dropped below the zero level and ventured into the negative territory. As a result of this policy, the fed accumulated treasury notes valued between $700-800 million in its balance sheet. Quantitative easing not only affected the US economy but had varied impacts globally. Quantitative easing helped in improving global liquidity levels due to an increase in the number of dollars in circulation. The position of the dollar as the global reserve currency means that many commodities are denominated in dollars. Since quantitative easing led to the depreciation of the dollar, the price of these commodities also followed the same trajectory. As one of the largest global economies, China was worried about the effects of the QE on its own economy. The Chinese economy is heavily dependent on commodities i.e., in buying raw materials and using them in production. The fall of the value of the dollar would lead to an accompanying rise in the value of the Yuan which had been kept artificially undervalued by China. The uncontrolled printing of money by the fed would ultimately result in an inflationary shock for China due to an increase in the price of raw materials. This is because the appreciation of the Yua...