1. Final Exam 3 questions: Question 1 (20%). No choice Question 1 (20%). No choice Question 2 (40%). Answer 8 out of 10 short questions. ONLY THE FIRST 8 ATTEMPTED ANSWERS IN YOUR ANSWER BOOK WILL BE GRADED Question 2 (40%). Answer 8 out of 10 short questions. ONLY THE FIRST 8 ATTEMPTED ANSWERS IN YOUR ANSWER BOOK WILL BE GRADED Question 3 (40%). Answer 2 out of 4. ONLY THE FIRST 2 ATTEMPTED ANSWERS IN YOUR ANSWER BOOK WILL BE GRADED Question 3 (40%). Answer 2 out of 4. ONLY THE FIRST 2 ATTEMPTED ANSWERS IN YOUR ANSWER BOOK WILL BE GRADED

2. Topic 3: Adjustment within the euro area European Monetary Union (EMU) launched in 1999 European Monetary Union (EMU) launched in 1999 Ireland adopted the euro Ireland adopted the euro Interest rates in the euro area set by the European Central Bank (ECB) Interest rates in the euro area set by the European Central Bank (ECB) ECB’s target is to keep average euro-area inflation below, but close to, 2 percent ECB’s target is to keep average euro-area inflation below, but close to, 2 percent

3. Pros and Cons of joining EMU Pros Pros Lower risk premium on interest rates  greater investment  higher income Lower risk premium on interest rates  greater investment  higher income Cons Cons Domestic interest rates and exchange rate no longer respond to shocks to the Irish economy Domestic interest rates and exchange rate no longer respond to shocks to the Irish economy

4. Optimal Currency Area (OCA) Members can perform well using a common currency Members can perform well using a common currency Asymmetric shocks Asymmetric shocks Shocks that affect some economies but not others, or common shock that affects economies in different ways Shocks that affect some economies but not others, or common shock that affects economies in different ways

5. Joining a common currency area Costs of joining a common currency are lower when: Costs of joining a common currency are lower when: Fewer asymmetric shocks Fewer asymmetric shocks Greater factor mobility Greater factor mobility Both characteristics help to prevent actual output from deviating too much or for too long from potential output Both characteristics help to prevent actual output from deviating too much or for too long from potential output

6. Asymmetric shocks When bad shocks hit a country that is not part of a currency union: When bad shocks hit a country that is not part of a currency union: Central bank cuts interest rates to spur domestic demand Central bank cuts interest rates to spur domestic demand Exchange rate depreciates which helps to boost international competitiveness Exchange rate depreciates which helps to boost international competitiveness Opposite occurs when good shocks hit Opposite occurs when good shocks hit

7. Asymmetric shocks Euro-area interest rates and the euro exchange rate will respond to common (symmetric) shocks to the euro area Euro-area interest rates and the euro exchange rate will respond to common (symmetric) shocks to the euro area But they will not respond to asymmetric shocks that hit Ireland But they will not respond to asymmetric shocks that hit Ireland

8. Real interest rate channel Real interest rate Real interest rate r = i – p e where r = real interest rate r = real interest rate i = nominal interest rate p e = expected inflation

9. Real interest rate channel Low real interest rates boost economic activity Low real interest rates boost economic activity High real interest rates depress economic activity High real interest rates depress economic activity Dilemma: faster growing members of EMU may have higher inflation rates and thereby face lower real interest rates

10. Divergence Divergence in inflation rates  divergence in economic performance  further divergence in inflation rates  … etc.

11. Divergence in the euro area Dispersion of inflation much lower during EMU than in early 1990s. Similar dispersion to the United States Dispersion of inflation much lower during EMU than in early 1990s. Similar dispersion to the United States Growth dispersion not unusually large Growth dispersion not unusually large However, both inflation and growth dispersion are persistent However, both inflation and growth dispersion are persistent

12. Sources of euro-area divergence Convergence Convergence nominal interest rates nominal interest rates price levels (though mostly pre-EMU) price levels (though mostly pre-EMU) Balassa-Samuelson effect Balassa-Samuelson effect Asymmetric shocks Asymmetric shocks National policies National policies Pro-cyclical fiscal policy Pro-cyclical fiscal policy

13. Factor mobility Labour and capital move to booming region, boosting supply of output in that region Labour and capital move to booming region, boosting supply of output in that region  reduces overheating pressures Labour and capital move out of depressed region, reducing supply of output in that region Labour and capital move out of depressed region, reducing supply of output in that region  reduces excess capacity

14. Real exchange rate channel If faster growing members of EMU have higher inflation rates  real effective exchange rates are appreciating  dampens export growth If faster growing members of EMU have higher inflation rates  real effective exchange rates are appreciating  dampens export growth Converse holds for slower growing members of EMU Converse holds for slower growing members of EMU

15. Real exchange rate channel This channel requires price and wage flexibility This channel requires price and wage flexibility Does not have much effect on relatively closed economies Does not have much effect on relatively closed economies Can take a long time to operate Can take a long time to operate

17. Cross-country fiscal transfers The euro area lacks a cross-member fiscal transfer mechanism that could help to reduce divergences The euro area lacks a cross-member fiscal transfer mechanism that could help to reduce divergences

18. National fiscal policy EMU works best if member countries avoid pro-cyclical fiscal policy EMU works best if member countries avoid pro-cyclical fiscal policy Stance of fiscal policy measured by cyclically-adjusted (structural) fiscal balance Stance of fiscal policy measured by cyclically-adjusted (structural) fiscal balance (Actual) budget balances automatically rise during booms and fall during recessions (Actual) budget balances automatically rise during booms and fall during recessions

19. Structural fiscal balance Improvement of the structural fiscal balance implies fiscal contraction Improvement of the structural fiscal balance implies fiscal contraction Deterioration of structural fiscal balance implies fiscal expansion Deterioration of structural fiscal balance implies fiscal expansion

21. Comments Overall balance = current balance + capital balance Overall balance = current balance + capital balance Government is running a large capital deficit Government is running a large capital deficit Overall balance = primary balance – interest payments Overall balance = primary balance – interest payments

23. Fiscal policy Sustainability of EMU put at risk if national governments do not run counter-cyclical fiscal policies Sustainability of EMU put at risk if national governments do not run counter-cyclical fiscal policies Loosen fiscal policy when times are bad, and tighten when things are good. Loosen fiscal policy when times are bad, and tighten when things are good. Stability and Growth Pact (SGP) limits fiscal deficits to 3% of GDP Stability and Growth Pact (SGP) limits fiscal deficits to 3% of GDP Some members are violating rule Some members are violating rule

24. Fiscal balance Government medium-term objective is to have the fiscal position close to balance Government medium-term objective is to have the fiscal position close to balance Arguments for large fiscal surplus in the short term Arguments for large fiscal surplus in the short term Room to manoeuvre if bad shock hits Room to manoeuvre if bad shock hits Future age-related spending pressures Future age-related spending pressures National Pension Reserve Fund National Pension Reserve Fund