Question

Imagine that a single large country within the Euro area, for example, Germany, carries out a fiscal expansion, in which its government purchases more of its own country’s output through, for example, a major infrastructure renewal program. What would be the effect on the other members of the Euro area? Assume that the Euro zone was at full employment before the fiscal expansion.

(a) Start by using the DD-AA model, considering the Euro area to be a single economy with an exchange rate that floats against the rest of the world. Then consider the channels through which the German policy change could affect other currency union members if the change is permanent. That is, what are the dynamics between countries’ economies within the monetary (currency) union? What if the fiscal expansion is temporary?

(b) Now imagine that the Euro area is in a liquidity trap, with the ECB policy rate fixed at zero. How do you think a temporary German fiscal expansion affects other currency union members? What about a permanent expansion?

(c) What can other members of the Euro Area do in response to Germany’s policies?

Answer 1