Sample Paper on Effects of ECB Greek bail out on interest rates

International Economics

Part (a): Effects of ECB Greek bail out on interest rates

Originally, when the European Central Bank chose a bailout, they expected interest rates in the Greece economy to remain low and then rise a notch higher after the economy started recovering. Upon approval of a bailout by the Eurozone finance ministers, the Greek loans repayment program was to be extended for some period of time subject to certain stringent terms such as a cut on Government spending. Therefore, interest policies stipulated by the European Central Bank (ECB), though they would to a large extent destabilize prices in the economy of Greece, were to help increase the interest rates in Greece. Notably, the European Central Bank (ECB) set policies are subject to approval and satisfaction by member states. The European Central Bank (ECB) strategy was to ensure a stabilization of Greece output without much emphasis on whether the prices of basic commodities would be affected by this policy action or not. Since acceding to the euro, the interest rates in Greece have remained at all-time low, sometimes even being negative.

The interest policies applied by the European Central Bank (ECB) in most cases differ significantly with those of the Bank of Greece. Over the past decade, the interest rates in Greece have been trending at a negative rate given the slow pace at which this economy has been growing over the last decade. Recently, the European Central Bank (ECB) agreed to increase their interest rates from the current existing one but assured its member states that they were safe with an aim of further helping bail out the Greece economy from collapsing. However, the interest rates set by the European Central Bank (ECB) were considered too low for the Greece economic conditions.

From the above graph, it is apparent that a potential decrease in interest rates will lead to an increase in money supply from MS1 to MS2 due to lower lending rates from the financial institutions operating in Greece. As a result, the demand for investment opportunities will increase but only in the short run enabling the country (Greece) to clear its accrued debts. When European Central Bank (ECB) went out for a bail out, the plan was to extend the period of monetary easing in Greece to enable the country mobilize its resources and recover from the possible economic collapse. At first, the economy of Greece experienced a boom with this monetary plan and at lower European Central Bank (ECB) interest rates. The Greek economy as earlier noted had been operating at negative interest rates for almost a decade, a possible sign of deflationary pressures (the liquidity trap).

As a result, less money would be flowing in the Greece economy, reducing the liquidity gap. Greece, being a member of the Eurozone, could not inflate its interest rates from the one set by the European Central Bank, further intensifying their sovereign debt bubbles. The interest rate in the Greece economy was expected to remain at a record low and the supply of money to increase in the economy.

Part (b): Expected outcome of ECB bail out policy on the Greece economy

The amount of money held for transaction, speculative and precautionary purposes are direct functions of the rates of interests in an economy. By reducing the interest rates, the European Central Bank (ECB) aimed at allowing the Greece financial institutions to borrow money from it as they had ran out of funds. As a result, the interest rates in these financial institutions were to remain low to enable the populace borrow more money for investments into the economy. From monetarist point of view, a decrease in the rates of interests means that more money will be circulating in the economy of Greece as more would be able to borrow from banks. The aim of the European Central Bank (ECB) was bail out Greece from within using its own Government to implement some of the policies stipulated as pre conditions to the bail out.

In essence, the quantity of money held by a household in Greece depends on individual incomes and the rates of interests charged for borrowing at the financial institutions. By allowing more money to circulate into the Greece economy, more investment opportunities opened up and Greece temporarily experienced a boom in its economy. As explained in the graph below, a decrease in interest rates, for instance from 7% to 6% leads to an increase in money supply and money demand.


Therefore, any shift in the Aggregate supply and demand for money due to the low rates of interest in the economy will lead to a temporary change in the National Income in the economy as it did with the Greece economy. The increased economic activities in Greece according to the European Central Bank (ECB) were to help the economy recover from recession and with time enable Greece pay off the debts it owed other nations and international financial institutions.

Part (c): Effects of expansionary fiscal policies on the Greece economy

In economics, the question whether to increase Government spending and employing other expansionary fiscal policies will have any significant impact on the GDP is a debatable one. For instance, assuming that the Government decides to increase their spending, the economy is likely to experience the multiplier effect. This is because any potential increase in Greece government spending on public goods, more employment opportunities are likely to be created and therefore more income for households. The aggregate demand for basic commodities will most likely increase leading to a potential increase in commodity prices.

Any change in any of the components that determines aggregate demand of commodities such as government spending will result into a shift in the aggregate demand curve as shown in the graph above.

Some economists do argues that increasing government expenditures, for instance through increased taxes, would in the long run crowd out private investments in an economy leading to no significant increase in the aggregate demand (the crowding out effect). When private investors are scared away from investing in the economy, the production and supply of some commodities will reduce considerably leading to a scramble for the few existing commodities. In such instances, it will most likely lead to an increase in prices of basic commodities and the provision of quality service delivery in the Greece economy.

The increase in aggregate demand will lead to an increase in the prices of commodities and a decrease in value of financial assets as people will resort to buying less in the long run. The net exports of Greece will reduce significantly as the goods will be expensive prompting the government to reduce its aggregate expenditure in both in the long and short run. A shift in AD curve from AD1 to AD2 implies a change in price levels of a commodity or a service. In essence, expansionary fiscal policies aim at ensuring an increase in economic growth and creating employment opportunities.

Part (d): Significance of ECB bail out of Greece

Overall, the bail out of Greece by the European Central Bank (ECB) was a healthy strategy as had they not acted otherwise, Greek could have returned to the drachma, the original currency. Similarly, Greece could have suffered prompt currency devaluation and worst inflation in the history of the country coupled with crises in their banking sectors. Arguably, most Greeks could have become jobless as most of the remaining operational companies could have closed down had the country not been bailed out by the European Central Bank (ECB). Though the European Central Bank (ECB) bail out was not that sufficient, it at least served to cushion the country against total economic collapse.

European Central Bank (ECB) also benefited from the bail out as is depicted itself to member countries that it was a bank of last resort and they would step in to help the indebted member states. The bail out by European Central Bank (ECB) was also necessary to allow the Greek authorities to design relevant and detailed reforms that they could implement in ensuring a recovery of the economy.

Part (e): Arguments against a common currency from economics perspectives

Some economists argue from the fact that different countries have diverse fiscal and monetary policies that helps in the running of such economies. Therefore, when faced with any form of deficit in the economy such as recession, specific fiscal and monetary policies relevant to such countries may be appropriate as in the case of Greece. Similarly, they argues that different countries have different economic capabilities and performances making it a challenge to adopt common fiscal and monetary tools in cases of eventualities and shocks in different economies. For instance, the ECB has set extremely high inflation levels for member states, which is not working for some countries like Greece that are heavily indebted.

Such indebted countries (Greece) arguably pull down the economies of relatively strong countries like Germany making the use of single currency a challenge. Additionally, the opposing economists argue that the adoption of single currencies to some extent has deflationary effects in economies of countries joining the Eurozone. The Eurozone for instance forces its members to adhere to strict deficit and inflation caps making such countries to deflate their economies largely. For example, in 2011, Estonia upon joining the Eurozone was forced to first adhere to the Maastricht conditionality of the EBS. The effects were increased unemployment in the country by an almost double margin with most companies in the country closing down.  In addition, the opposing economists asserts that in instances of external economic shocks such as the 2008 economic world economic crisis, no cushioning is provided to avert such shocks. The 2007-2008 world economic crisis saw the Eurozone currency exchange drop significantly and the budget fell above 1% making it unpredictable.

Lastly, the transitional costs involved when moving to a single currency ranging from introducing new vending machines to issuing of new currencies, though short term are significantly high. Some economist also questions whether it was right for Greece to join the Eurozone given that differential inflations exist at the Eurozone. Others argue that under the Bank of Greece, Greece attained stronger economic convergence as compared with the European Central Bank (ECB) and vehemently calls for complete austerity in Greece financial markets.