Understanding Macroeconomics, EU Integration, and the Euro

Posted on Jan 10, 2025 in Business Administration and Management (BAM)

Macroeconomic Equations

GDP = C + I + G + (NX) Y = C + I + G + (X – M)

Stotal = Y – C – G / S = I + NX (S = I + CA)

Y – T – C = private T – G = public

Key Financial Terms

Current Account: exports – imports

Financial Account: capital flows

Capital Account: movements of assets

Spot Rate: buy at the actual price

Forward Rate: expected future value

Future Rate: you decide the rate today

Optional Rate: premium

Monetary Policy and Exchange Rate Regimes

US: monetary independence and capital mobility

China: monetary independence and exchange rate

EU: exchange rate and capital mobility

Evolution of European Economic Integration

1. Key Milestones

  • 1951 European Coal and Steel Community: common market, neutralise competition.
  • 1957 Treaty of Rome: trade, goods and capital move freely. New institutions: Commission, Council of Ministers, Assembly, Court of Justice = European Economic Community.
  • 1979 European Monetary System: linked currencies. ECU: prevent movements of 2.25% around exchange rate, and exchange rate mechanism, extension of European credit facilities, European Monetary Corporation Fund: Central Banks.
  • 1987 Single European Act: revises Treaty of Rome and creates an internal market, expands community powers and sets rules for European institutions.
  • Economic content of the monetary union: inflation rates no more than 1.5% above the average. Government finances: deficit not higher than 3% and debt cannot exceed 60% of GDP. Exchange rate: +/- 15%. Long-term interest rate: 2% points above the lower inflation rate.

Later Treaties

  • 1997 Treaty of Amsterdam: addresses shortcomings of Maastricht, to enlarge the community.
  • Concerns about democratic deficit corrected in the Treaty of Nice: institutional structure reform.
  • 2009 Lisbon Treaty: new and better institutional and political basis.

EU Institutions

  • Commission: executive body, operates as a cabinet government with 28 members called commissioners.
  • European Council: comprises the heads of states and has a council president and includes the president of the commission. Has no formal legislative power, is strategic.
  • European Parliament: with the other two exercises the legislative function of the EU.
  • Court of Justice: interprets EU law and ensures equal application.
  • Central Bank: administers monetary policy of the Eurozone.

European Central Bank (ECB)

2. ECB Overview

European Central Bank: monetary policy, 18 Eurozone countries, Treaty of Amsterdam, Draghi.

Tasks: conduct foreign exchange operations, defines monetary policy, manages reserves, advisory functions, collects statistics, international cooperation, contributes to prudential supervision and financial stability, issuance of banknotes (has the power to print them).

Objectives: maintain price stability, sustainable non-inflationary growth, and high level of employment.

Functions: definition and implementation of monetary policy, conduct foreign exchange operations, manage foreign reserves of the European System of Central Banks, issue euro banknotes, and promote smooth operation of payment systems.

Monetary Policy Tools

Monetary policy: Standing facilities on deposits and credits. Open market operations with main refinancing operations, long-term refinancing, and operations of structure and adjustment. Reserve requirements (base, ratio, remuneration).

European Economic Integration

  • 1979 ECU: fluctuation +/- 2.25%.
  • 1992 Maastricht: fluctuations increased to +/- 15%.
  • 1997 Stability and Growth Pact: preventive arm and dissuasive (recommendations that end in sanctions).
  • 2006 Stability Pact: 3% deficit and 60% debt. Reform failed due to special rules and a high amount of exceptions.
  • Stability and Growth Pact (1997): to ensure economic monetary union. Supervision of members’ fiscal policies and sanctions. Main objective: safeguard public finances. Criteria: deficit lower than 3% and national debt lower than 60%.

Euro Expectations vs. Reality

3. Eurozone Analysis

Expectations: minimization of transaction costs, maximization of single market, prices and labor costs convergence.

Results: elimination of currency transaction costs, greater price transparency, price convergence, elimination of exchange rate uncertainty, stimulates investment, increase in trade and investment flows.

Problem EU: monetary policy is supranational but fiscal policy is national. ECB is not allowed to bail out members or make direct transfers to help with debts; however, the ECB buys debt in secondary markets, which some consider illegal.

Alternatives to bailouts: monetary solution (increase Euros and issue Eurobonds) and fiscal discipline, fiscal compact + limited role of ECB, solidarity, split (reversal of the euro).

Euro Plus Pact: project on banking regulatory reform, European fiscal stability facility, and European financial stability mechanisms.

Objectives: fostering competitiveness and employment, contributing to the sustainability of public finances, reinforcing financial stability, and tax policy coordination.

Banking Sector Reform

Banking sector reform: increase capital requirements and deposit guarantees to 100,000.

Financial Backstops

  • European Financial Stability Facility: 2010 ECB provides financial assistance to the Euro area to preserve stability, done to bail out. Authorized to act on a precautionary program, provide loans to countries with financial difficulties, intervene in the primary and secondary debt markets, and finance recapitalizations of financial institutions through loans to governments. Temporary until 2013.
  • European Financial Stability Mechanism: emergency funding program for Ireland and Portugal. Request for financial assistance, macroeconomic adjustment agreed with the Commission and ECB.
  • Permanent financial backstop: public institutions with a lending capacity of 500 billion euros.

ECB Response to Crisis

ECB response to crisis: 7 starts providing extra liquidity, 8 decides on extraordinary liquidity measures, 9 announces purchase program for covered bonds, 10 securities markets program, 11 measures to support bank lending money market activity, 12 outright monetary transactions, 13 provides forward guidance on future interest rates.