Question

Answer question 13 on page 740 (eBook: p.708) under “Problems”,

Chapter 35 – Open–Economy Macroeconomics: The Balance of Payment s and Exchange Rates.

13. Explain why the European Central Bank cannot selectively change interest rates in any of the 16 EU countries that have adopted the euro—for example, lowering the interest rate to stimulate the economies of Greece, Ireland, or Spain, while maintaining the interest rate in other countries?

Answer 1

Lowering the interest rates in select countries like Greece, Ireland or Spain might be seen as a good move, but a deeper look into the same doesn't suggest so. The ECB lowers the interest rates by buying bonds from the select countries. Initially, because of the decrease in rates, the consumption in these countries will soar, and soar to an extent that the market will fall short of the supply due to the sudden increase in demand. The banks in these countries lend out loans at lower interest rates, and the money supply in the economy is increasing as well. But the downside is that, given these countries are sensitive to change, all the above factors contribute to inflation. When demand is too high, the sellers have no idea but to set high prices to match the demand. Weaker fiscal policies in these countries just add fuel to the fire and the European Central Bank is ultimately forced down to deploy contractionary fiscal and monetary policies in these. When this happens the agenda of the European Central Bank is broken, as we know it strives for the growth and price stability of theEurozone as a whole. With the same currency and different inflation rates across every country in the Eurozone just defeats the purpose of the European Central Bank. Therefore they resort to fixed interest rates across the 19 member states of the Eurozone.

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