Thursday, 15 September 2011

oh, EUROzone!... What have you done?

What is the relationship between interest rates and inflation. Why have the ECB and the Bank of England reacted differently to rising inflation?

There are two types of inflation: cost-push (caused by higher production costs – oil, labour or import prices) and demand-pull (caused by higher demand for goods). There are two ways for the government to control it (fiscal and monetary policy). The fiscal policy is about taxes and government spending and monetary is about interest rates. If interest rates are low it enables people to spend more and that causes demand-pull inflation. On the other hand, if the economy grows too fast, the central bank of a country can decide to increase interest rates in order to reduce people’s demand and lower inflation.

In the UK interest rates have remained at the same, historically low level of 0.5% since March 2009, while in the Eurozone they were increased from 1% to 1.25% and there is a pressure for further rise due to the increasing economic growth in most of countries. Why are there two different reactions to rising inflation?

Raising interest rates increase the cost of borrowing, and there are concerns this may cause the UK to fall back into recession.

"Premature rate increases will have negative effects on growth and jobs. With wage increases remaining subdued, we strongly urge the MPC to hold its nerve and avoid taking any action that may risk derailing the recovery." said David Kern, the BCC's chief economist.

The ECB decided to increase interest rates to lower the inflation by decreasing demand.

""Monetary data continue to point to a modest recovery in euro area money and loan growth," While the data in itself do not indicate upside risks to price stability that require further monetary tightening, they are further proof that the economic situation has changed substantially since 2009 -- which is why the ECB thinks that extremely low interest rates are no longer appropriate.” said Christoph Balz, economist at Commerzbank.

Is the inflation currently being experienced in the Eurozone cost-push or demand-pull? Illustrate your answer with the help of a diagram.

The inflation in the Eurozone is cost-push due to, for example, higher oil prices. If prices of production and transport go up it causes prices of the product to raise. 

"The combination of high oil prices, a strong euro, and fiscal and monetary tightening has started to dent the economic mood in the euro zone," said Martin van Vliet, economist at ING. 

What is the relationship between interest rates and the exchange rate?

An increase in interest rates will raise the exchange rate, and vice versa. Higher interest rates attract inflows of funds from overseas and this rise in demand for pounds can push up the price of sterling.

Why is there some concern about the ‘economic sentiment’ indicator in the Eurozone?

The Economic Sentiment Indicator can be used as a measurement method of European Union’s economic strength. The five indicators are: Industrial Confidence Indicator; Services Confidence Indicator; Consumer Confidence Indicator; Construction Confidence Indicator and Retail Trade Confidence Indicator. The concern about it is that, the ESI shows the economic health of the EU more as a whole, than individually. Most EU members reported an increase in sentiment in 2010, it was mainly caused by the 4 points increase in Germany. Other countries that recorded a major increase were Poland (!), France and Italy. In contrast, the ESI remained weak in Spain, Portugal and Greece.

What is the relationship between interest rates and economic growth? Explain the process by which a change in interest rates could affect AD and then economic growth and employment.

An economic growth is an increase of value of output of goods and services in an economy over a period of time. It is measured mainly by GDP (or GNP). A raise in interest rates would cause people to spend less (lower demand) and, consequently, prices to fall. It would probably lead to lower economic growth (or a recession – two consecutive quarters of negative economic growth) and higher unemployment. On the other hand, reducing interest rates would cause just the opposite result. People would be able to spend more (assuming that their low confidence would not lead them to saving their money) and cause the economic growth, and lower unemployment.

Why is this interest rate rise (and possible further rises) likely to hurt countries, such as Ireland and Greece more than other countries within the Eurozone?

"The hike is unwelcome for peripheral countries, but arguably the core member states were in need of this move already some time ago," said ECB president Jean-Claude Trichet

Higher interest rates in these countries would cause lower consumer spending even more and increase unemployment. It would also hurt small businesses and individuals who are already have problems with repaying their loans. The economies of Greece, the Republic of Ireland and Portugal would remain trapped by large debts, high unemployment, weak consumer spending and uncompetitiveness.

That's what I think.


No comments:

Post a Comment