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EC316 > Europe and the Recession > Flashcards

Europe and the Recession Flashcards

1
Q

Why are European economies very open?

A
  1. They are all very open
  2. Wide exchange rate fluctuations in 1920s and 30s, lead to crisis between wars
  3. Common agricultural market
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2
Q

Why are european economies very open and why is international trade important for national income ?

A

International trade important for national income
– High share of exports and imports in total income
– Demand/income is more exposed to fluctuations in the exchange
rate (relative prices)

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3
Q

What is a common agricultural market ?

A

Common Agricultural Policy (CAP) in European countries
– Single ECU (unit of account) price for agricultural products – ECU being composed of national currencies
– Devaluation of one currency meant change in relative prices across countries
– exposing prices once again to fluctuations in the exchange rate

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4
Q

What us the Bretton woods agreements ?

A

-Was an established way to keep volatility in check
- A system of currencies with common peg to the US dollar
- “central rate” with any deviations kept with in a narrow band

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5
Q

What happened when Bretton Woods ended ??

A
  • Free fluctuations in the relative competiveness of countries
  • Initially some countries benefitted from this, but after inflation followed
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6
Q

The EUROPEAN MONETARY SYSTEM (1978)

A
  • An exchange rate agreement but only for european countries with the DM as the anchor currency
  • It collapses in 1992 again due to the incompatibility between the policy goals of Germany and the RoE
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7
Q

What is the Maastricht Treaty ?

A
  • In 1992 this was signed and its the treaty that decided to adopt a single currency
  • There was a convergency criteria for countries aspiring to join
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7
Q

Criteria for EMU admission - Inflation rate

A

The year preceding accession, cannot be more than 1.5pp above that of the 3 best preforming states

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7
Q

What is so important about a single currency

A
  • This means it is impossible for a country to devalue
  • A condition for starting the emu was therefore the convergence of macroeconomic variables
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8
Q

Criteria for EMU admission - public deficits and debts

A
  • The ratio of government deficit to GDP must not exceed 3%
  • The ratio of government debt to GDP must not exceed 60%
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9
Q

Criteria for EMU admission - Exchange rate

A

For the last 2 years fluctuations must be within the band

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10
Q

Criteria for EMU admission - Exchange rate

A

One year before examination, on avg long-term rate that does not exceed by more than 2pp that of, at most, the 3 best preforming members

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11
Q

What are 2 possible conditions for OCA

A
  1. Countries either face similar shocks
  2. OR there is high factor (labour) mobility
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12
Q

Can the euro itself make business cycles more synchronised ??

A
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13
Q

Are EU countries subject to asymmetric shocks ??

A

Yes as not all countries are synchronized as labour mobility is low

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14
Q

Does labour mobility matter ?

A

-Movement of workers between these EU countries can be a important adjustment mechanism when faced with asymmetric shocks
-EU labour mobility is low
-Since 2000 labour mobility has been rising

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15
Q

What is Labour mobility

A

Labour mobility is the ease workers are able to move around within an economy and between different economies

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16
Q

So is EU a optimal currency area ?

A

-With labour mobility not being optimal
-Asymmetric shocks are common, however, the EU doesnt really have an adjustment mechanism

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17
Q

What does no adjustment mechanism mean ??

A

This means that a lot of times prices need to adjust, leading to a long and painful adjustment process

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18
Q

Fiscal policy as an adjustment mechanism ?

A

This would mean fiscal transfers from struggling nations to thriving ones
-Would need a centrailzed fiscal authority which the EU does not have

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19
Q

What are the benefits of a monetary union

A

-Reduces uncertainty, as volatile exchange rates will not affect price and demand

-Reduces transaction costs, as there are no foreign exchange costs

-Price transparency

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20
Q

What is the downside of a monetary union

A

The loss of exchange rate as a automatic stabilser in the event of an asymmetric shock

21
Q

The EU system of central banks

A

One EU central bank
- Along with 27 central banks of each member state
-Implementation of tasks are decentralised and each member gets one vote

22
Q

Some key facts about the euro over the past 20 years

A
  • Second most important currency in the world
    -Difficulties experienced by the RIIGS countries, demand shocks, building large deficits and no way to adjust as they cant devalue
23
Q

What is an economic bubble ??

A

This occurs when prices of assets and securities rise above their true or fundamental value
Once this “bubble” bursts the prices collapse

24
Q

What does sub-prime mean in macroeconomics ?

A

-In the context of the housing crisis, mortgages were given to people who had a relativley high probabilty of not being able to pay it back

25
Q

What explains the housing bubble after 2000

A

-There was a long period of extremely low interest rates that highly incentivised borrowing to buy a house… which then lead to a financial expansion which in turn created a credit bubble

-there was no need to raise interest rates as inflation was low

-The house prices were expected to continue rising

-There was what is called crowd psychology, everyone believed cuz house prices were rising they would just continue and that ‘housing’ is an easy money maker

26
Q

What lead to the rapid rise in house prices after 2000

A

-Borrowing to buy a house became even easier as banks decided to make mortgage approvals much less strict
-Households that were believed to not be able to pay back mortgages were awarded them (sub-prime mortgage)
-The banks did this as they believed there was no actual risk to them, they repackaged the risky mortgages and sold them to investors as mortgage backed securities

27
Q

What originally triggered the reccession in the summer of 2007

A

-All of the sub prime mortgages started this crisis
-As house prices stopped rising there was increasing rates of defaults on mortgages in sub-prime mortgages
-When the households started to default the underlying properties were foreclosed and trasfered back to the banks
-Since the property was now less then the initial loan, the bank made a loss

28
Q

So how did the crisis in the housing market lead to a global economic crisis in 4 short summations??

A

1) sub-prime mortgages
2) crash in housing market
3) then leading to the crash in the financial markets
4) which resulted in the real economy being impacted

29
Q

How did this bubble become a financial crisis ??

A

-The bank acts as an intermediatery between borrows and lenders
-The bank experienced solvency problems, as the value of the asset declined under the level of liabilities, so the bank became insolvent

-This led to the banks having liquidity problems and had difficulties repaying investors

30
Q

what role did “leverage” play in how housing bubble became financial crisis

A
  • Having a high leverage ratio is risky
    -In the event of a drop in value of your assets, the bank could become insolvent
    -The banks saw the raising house prices as having high leverage would result in hughe profits if none failed
31
Q

What happens if the value of assets decrease by 20%

A
32
Q

Why did banks have such high leverage ratios??

A

-They underestimated risk
-Was a high bonus incentive for managers
-There was regulation on minimum capital ratio, banks found ways to avoid this

33
Q

What is securitization ??

A
  • The creation of securities based on a bundeling of assets, e.g. mortgages
    -This is meant to be an instrument for risk diversification
    -When banks diversify, say using MBS, the underlying asset should not be correlated
    -But sub-prime mortgages were highly correlated, as properties located in similar bubble areas were all provided to borrowers with low credit ratings
    -They were given a high rating by credit rating agencies
34
Q

What is a structured investment vehicle ?

A
  • They are off-balance-sheet operations that are legally independent from banks

On the liability side there was borrows from investors, typically in the form of short term debt

On the asset side there was holds from various form of securities

35
Q

What is the shadow banking system ??

A

-Leverage of the banking system as a whole was much higher than perceived
-Through SIV’s and the shadow banking system, banks managed to hide some of the risks and their exposure
-As of Oct 2008, there were no SIV’s left

36
Q
A
37
Q

So what actually happened for the housing bubble to turn into a financial crisis

A

Highly leveraged banks, using complex financial instruments, considered that risks were priced appropriately and markets awash with liquidity

So when the housing bubble burst
1) some mortgages went bad
2)High leverage implied a sharp decline in.
capital of banks
3)banks started selling assets to build cap

Because they were selling the assets at lower prices this then in-turn devalued other assets and levels of capital began to decline further

And then low solvency lead to the bankcruptcy of some banks and those that survived stopped lending to eachother or anybody else = the credit crunch

38
Q

how financial crisis became macroeconomic crisis - International spillovers

A

A sharp contraction of the US economy translated to the rest of the world and europe in particular

39
Q

What were the 3 major channels of international spillovers

A
  1. EU banks directly exposed to the US housing market through securities whos underlying asset were MBSs or CDOs
  2. Trade flows contracted due to demand contracting and trade credit dried up
  3. Increase in US. interest rates translated to European interest rates, making it difficult for firms to borrow

The housing prices started to increase which led to the same process happening in some European countries

40
Q

What was the policy response to the global finacial crisis
??

A
  1. monetary policy
  2. fiscal policy
  3. National and coordinated international actions
41
Q

What was the initial response ??

A

New monetary policy was introduced

42
Q

What monetary policy did the US introduce ?

A
  • Cut interest rates
  • Increase of Federal deposit insurance from 100,000 to 250,000 per
    account in order to prevent bank runs
  • Provision of wide spread liquidity to the financial system
  • Troubled Asset Relief Program (TARP)
  • Federal Reserve became the main buyer of mortgage- backed securities
43
Q

What did the fiscal policies aim to achieve ??

A

The governments used fiscal policy to replace private with public demand

UK - Temp cut in VAT from 17.5% - 15%
US - ARRA of $780 billion over 09 and 10

44
Q

What monetary policy did Europe introduce ??

A

Cut interest rates
* Unlimited liquidity for European banks at a fixed interest rate of maturities of up to a year
* Increase of the different kinds of assets accepted by the European Central Bank in exchange of cash (government bonds, private assets)
* Purchase of covered bonds by the ECB

45
Q

What limits did policy have when trying to respond to the global financial crisis

A

-At the end of 2008 major banks had dropped interest rates to 0
-They could do no more and the economy had fallen into a liquidity trap
-In liquidity traps the conventional measure of open-market operations to manipulate interest rates is not effective
-When the conventional tools cant be used the banks have some others they can use, however, they can be limited

46
Q

Why was the recovery so slow ??

A

On the aggregate supply side:
-The banking crisis has decreased the natural level of output
-Not expect it to go back to initial level

On aggregate demand side:
-Policy interventions are limited
-Risk of a liquidity trap

47
Q

What are the downsides of expansionary monetary policy ?

A

Higher inflation

48
Q

What are the downsides of expansionary fiscal policy ?

A

Higher government debt

49
Q

What is this graph showing ??

A

The liquidity trap and adjustment failure

50
Q

What happened to output in the medium run due to the financial crisis ??

A

-The crisis may have done lasting damage as natural level out output has been decreased
-Banking crisis weakened the ability of the banking system to allocate funds to the right borrowers.
-This left governments with increased deficits and increasing debts

51
Q
A

EC316 (7 decks)

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