ECON 1680 FINAL COLLEGE ASSIGNMENT!

If our country exports more, what happens to the value of our currency?

Demand for currency goes up

More exports = more demand for our currency = stronger currency

If people in our country invest abroad to stocks and bonds, what happens to our currency?

Domestic currency gets weaker, exchange rate falls

This is because investors in foreign assets need foreign currency, therefore they need to sell domestic currency in order to get the right currency

Why would a government want to devalue it’s own currency?

A weaker currency allows for:

• Exports cheaper (good for selling abroad)

• Imports more expensive (people buy domestic instead)

🎯 So the goal is:

• Boost exports

• Reduce imports

• Improve trade balance

• Stimulate the economy

✅ Final Answer:

Governments devalue their currency to:

• Increase exports

• Reduce imports

• Boost economic growth

• Improve trade balance

What were the disagreements about European Central Bank Policy

👤 Nicolas Sarkozy His criticism:

• ECB focuses too much on inflation

• Doesn’t care enough about growth & unemployment

• Wanted looser monetary policy (lower interest rates)

👤 Angela Merkel Germany’s response:

• Strongly supports ECB independence

• Prioritizes low inflation

• Against political interference

👤 Jean-Claude Trichet ECB response:

• Defended independence

• Said ECB must focus on price stability

• Ignored political pressure

💡 One-line memory:

• France wants growth, Germany wants stability, ECB stays independent

Big Picture Takeaways (for your exam)

• Exports ↑ → currency ↑

• Buying foreign assets → currency ↓

• Devaluation helps exports

• EU problem = no exchange rate tool

• ECB fights inflation, not politics

“If two countries in a monetary union get hit differently (one good, one bad), how can they fix it — and does the EU actually have these tools?” (asymmetric demand shocks)

⚡ Step 2: What is an asymmetric shock?

From your notes:

• Example: France vs Germany

• People suddenly prefer German goods over French goods

📉 What happens?

France (bad side):

• Demand ↓

• Output ↓

• Unemployment ↑

• Trade deficit

• Prices & wages ↓

Germany (good side):

• Demand ↑

• Output ↑

• Unemployment ↓

• Trade surplus

• Prices & wages ↑

The Core Goal is to restore competitiveness for France.

An asymmetric demand shock causes one country (France) to experience recession and another (Germany) to boom. According to Mundell, equilibrium can be restored through:

1. Wage adjustments

2. Labour mobility

3. Inflation differentials

4. Exchange rate adjustment

5. Fiscal transfers

However, in the EU:

• Exchange rate adjustment is impossible due to the euro

• Labour mobility is limited

• Wages are inflexible

• Fiscal transfers are weak

Therefore, adjustment is slow and incomplete, meaning countries may suffer prolonged unemployment and recession. This shows that the EU is not a fully optimal currency area.

As countries in the EU become more integrated (trade more, connect more), do shocks become more similar or more different?

🇪🇺 European Commission’s view:

• Integration → economies become similar

• So shocks will hit them in the same way

✅ Final Answer:

• Asymmetric shocks become LESS likely

• Because economies become more similar

Why does Paul Krugman disagree with the Commission’s vision that asymmetric demand shocks will be less common with integration?

🧠 Krugman’s idea (SUPER IMPORTANT):

Integration doesn’t make countries similar — it makes them specialize

Example:

• Germany → manufacturing

• France → services

💥 Problem:

If one sector crashes:

• One country gets hit hard

• The other doesn’t

✅ Krugman’s answer:

• Integration → MORE asymmetric shocks

Are prices still different across euro countries? And why? (or price discrimination)

📊 Reality (from De Grauwe):

• ❗ Prices are STILL different across eurozone

• ❗ More than in North America

🤔 Why do price differences still exist? 1. Transport costs

• Hard to equalize prices across distance

2. Taxes differ

3. Market segmentation

• Firms charge different prices in different countries

4. Consumer behavior

• People don’t always shop across borders

✅ Final Answer:

• Yes, price discrimination still exists

• More than North America

• Due to taxes, transport costs, and market separation

What is a currency peg?

When one currency’s value equals another, our currency = the value of 1 U.S. dollar

If a country is in trouble (current account crisis), should it ditch its fixed currency peg and devalue? What are the pros/cons?

🧠 First: what’s a current account crisis?

• Country imports more than exports

• Running out of foreign currency

• Basically: “we’re buying too much from abroad and can’t sustain it”

👍 Benefits of devaluing:

• Currency gets weaker

• Exports become cheaper → ↑ exports

• Imports become expensive → ↓ imports

• Fixes trade deficit

👎 Costs:

• Imports (like oil) become expensive → inflation

• People lose purchasing power

• Loss of credibility (markets trust you less)

✅ Final Answer:

Benefits: improves trade balance, boosts exports
Costs: inflation, loss of credibility, more expensive imports

Fixed exchange rates / currency pegs are fragile — what are better options?

Floating exchange rate

• Market determines value

• No need to defend a peg

Monetary union (like EU/Euro)

• Share a currency

• No exchange rate risk

If a country can’t pay its debt, should it default? (default means they can’t or wont pay back a debt)

👍 Benefits of default:

• Don’t have to repay debt

• Frees up money

• Can recover faster

👎 Costs:

• Lose access to borrowing

• Financial crisis

• Loss of credibility

• Banking problems

✅ Final Answer:

Benefits: reduces debt burden, frees resources
Costs: loss of credibility, financial instability, limited future borrowing

Why do expectations of devaluation determine whether a country abandons a fixed exchange rate?

Expectations matter because if investors expect devaluation, they trigger a speculative attack that makes defending the fixed exchange rate extremely costly, increasing the benefits of devaluation and causing the government to abandon the peg.

Why do expectations of default determine whether a country actually defaults?

Expectations of default lead investors to sell government bonds, raising interest rates and worsening the government’s financial position, which increases the benefits of default and can cause the government to default.

Why is setting a fluctuation band more common in fixed exchange rate regimes than a single fixed rate? In other words, what are the advantages of this method?

🧠 Think of it like this:

Instead of saying:

• “$1 = €1 exactly”

They say:

• “$1 can be between €0.95 and €1.05”

👍 Why is this better? 1. More flexibility

• Small changes don’t require intervention

2. Less pressure on central bank

• Don’t have to constantly defend exact rate

3. Prevents crises

• Reduces risk of speculative attacks

✅ Final Answer:

A fluctuation band allows limited flexibility in exchange rates, reducing pressure on central banks, lowering the need for constant intervention, and making speculative attacks less likely.

What went wrong in the ERM crisis (1992)?

🧠 First: what is ERM?

• System where European currencies were pegged to each other

💥 What caused the crisis?

1. Different economies

• Some countries weak (UK, Italy)

• Germany strong

2. Germany raised interest rates

• To fight inflation after reunification

3. Other countries forced to follow

• Even though their economies were weak

4. Speculators attacked weak currencies

• Investors expected devaluation

• Sold currencies (like British pound)

💣 Result:

• Countries couldn’t defend pegs

• UK and Italy left ERM

✅ Final Answer:

The ERM crisis was caused by economic divergence between countries, high German interest rates, and speculative attacks on weaker currencies, which made fixed exchange rates unsustainable.

What are the four Maastricht convergence criteria to join the euro? Explain the details of and motivation for each.

🧠 Goal:

Make sure countries are stable and similar before joining

Low inflation

• Must be close to lowest EU countries
  👉 Prevents unstable prices

Stable exchange rate

• Must stay within ERM band
  👉 Shows currency stability

Low government deficit

• Budget deficit ≤ 3% of GDP
  👉 Prevents overspending

Low government debt

• Debt ≤ 60% of GDP
  👉 Ensures sustainability

Should the European Central Bank act like a “backup bank” that saves countries in trouble?

What is “lender of last resort”?

• A central bank steps in and lends money in a crisis

👍 Arguments FOR:

• Prevents financial collapse

• Stops panic (investors calm down)

• Keeps borrowing costs from exploding

👎 Arguments AGAINST:

• Moral hazard → countries borrow too much

• Less discipline

• Risk of inflation

✅ Final Answer:

For: prevents crises and stabilizes markets
Against: creates moral hazard and weakens fiscal discipline

Why would Europe want a shared unemployment system?

🧠 Simple idea:

When one country is struggling:

• People lose jobs

👍 Why it helps:

• Money flows to struggling countries

• Boosts demand

• Acts like a shock absorber

✅ Final Answer:

A common unemployment system redistributes income to struggling countries, stabilizing economies and helping absorb asymmetric shocks.

Why would one shared European bond market have prevented the debt crisis?

🧠 Current problem:

• Each country borrows on its own

• No central backing

💥 What happens:

• If investors panic → they dump that country’s bonds

• Interest rates spike → crisis

🏛 With a common bond market:

• Debt is shared across Europe

• Strong countries support weak ones

• No panic on individual countries

✅ Final Answer:

A common bond market would pool risk across countries, prevent sudden spikes in borrowing costs, and eliminate the fragility caused by separate national bond markets.

👉 What is it asking?

• Why are countries like Greece and Italy struggling in the eurozone?

🧠 Core problem:

They are stuck with:

• ❌ No exchange rate control

• ❌ Can’t print money

💥 Their issues: 🇬🇷 Greece:

• High debt

• Weak economy

• Needed bailouts

🇮🇹 Italy:

• High debt

• Low growth

• Weak competitiveness

🔥 Why euro makes it worse:

• Can’t devalue currency

• Must use austerity (cuts + taxes)

✅ Final Answer:

Greece and Italy struggle due to high debt, weak growth, and lack of monetary tools (no devaluation or money creation), forcing painful adjustments like austerity.