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Today’s Agenda

Today’s Agenda. Fiscal Policy Goals and tools National fiscal policies in a monetary ( currency ) union The Stability and Growth Pact Content and reasons for the pact Problems with the pact Public debt levels and annual budget deficits. Fiscal Policy.

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Today’s Agenda

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  1. Today’s Agenda • FiscalPolicy • Goals and tools • National fiscalpolicies in a monetary (currency) union • The Stability and GrowthPact • Content and reasons for the pact • Problemswith the pact • Public debtlevels and annualbudgetdeficits

  2. Fiscal Policy = activities controlling the government budget • Government spending • Provision of public goods and services • Investments • Subsidies and income transfers • Government income • Taxes • Returns on investment

  3. Goals of fiscal policy • Income redistribution • Provision of public goods • Dealing with externalities • Investments to enable long term economic growth • Dampen business cycle fluctuations

  4. National fiscal policies in a monetary union • Good to have flexible national fiscal policies in case of asymmetric shocks… BUT • Large debt = large interest payments • Pressures on central bank to inflate • Lower credit rating  higher interest rate • Crowding out effect of fiscal policy of a small country is diminished in a large union • Incentive to increase budget deficit

  5. Crowding out of fiscal policy • Increased government spending to stimulate demand increases money demand (government a major player in the domestic money market) => Md => i  => (C+I) => AD  (!) • When a country enters a monetary union, it becomes a small player => Md increases only little • Less crowding out for one country => incentive to spend more • When all countries do the same thing, interest rates increase a lot • When one country in a union spends more, interest rates increase for everybody!

  6. Solution: restrict fiscal policy • Countries should not have public debt over 60% of GDP when entering EMU • Stability and Growth Pact in the EMU • Annual deficit limited to 3% • Council can impose a sanction on a country unless mitigating circumstances (e.g. natural disaster or GDP decreases) • A deposit of max 0.5% of GDP, which turns into a fine if deficit not corrected in two years • Balanced budgets in the medium term (= over the business cycle) • I.e. in the long run no new debt!

  7. ”Stupidity Pact”? • The Stability and GrowthPacthasreceivedarguments for and against • Romano Prodi calledit the ”StupidityPact” in 2002 • In groups, try to comeupwitharguments for and against the pact!

  8. Arguments for

  9. Arguments against

  10. Public debt (% of GDP) Source: Eurostat

  11. Budgetsurplus (deficit) % of GDP Source: Eurostat

  12. Currentdebtcrisis • Slowgrowth and negativegrowth (partlydue to financialcrisis) hasworsened the situation in countireswithlargedebt to beginwith • Financial crisisaffectedbanks and govenrmentsneeded to supportthem • Largerinflation in somecountries (likeGreece) without the possibility of devaluation of currencyhas led to poorcompetitiveness • Also, as capital leaves the country, itdoesnotaffect the exchangerate (as itwouldif the country haditsowncurrency), sothere is no boost for the exportindustry • Ifinvestorsstartquestioning a country’sability to paybackitsdebt, the interestratewillrise (riskpremium), whichincreases the governmentexpenditures and makesitmoredifficult to payback the loans

  13. Laborcosts in crisiscountriesincreased

  14. Governmentbondrates

  15. How to reducedeficit and debt? • When GDP decreasesorincreasesslowly, governmentincomedecreasesorincreasesveryslowly (unlesstaxesareincreased, which in turnreduces GDP growth) • At the sametimegovernmentexpendituresincrease • For example, moreunemployedpeople to support • Manyexpendituresare ”structural” and needshanges in legislation and thereforearedifficult to cut • Governmentcost (salaries, ongoinginvestments, publicserviceslikehealthcare and education) • Benefits and incometransfers (unemploymentbenefits, incomesupport, childbenefits etc.) • Also, when GDP decreases, evenwith no extradebt, ratio of debt to GDP increases

  16. Pre-Lecture Assignment 1. Howcan a country join the EU? 2. Howcan a country join the EMU? (Whatare the criteria and procedures of entry into EU or EMU)? 3. Doyouthinkit is difficult to become a member of the EU or EMU? 4. Whenthinkingabout the theoryrelated to tradeareas and the theory of OCA’spresentedduringthiscourse, doyouthinkthat the criteria for enlargementwerechosenwell?

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