Question

Greece is a member of the Eurozone. It uses the Euro as its main currency. Hence, the Greek currency is fixed relative to other members of the Eurozone but the value of Euro fluctuates relative to other currencies. Hence we can view the Greek currency as being flexible relative to countries outside the Eurozone. Also note that for a prolonged period of time, the Greek government was spending more than it was raising in tax revenue. Creative accounting understated the size of government borrowing until the late 2000s before the real size of the government debt and deficit was revealed. 1A trade weighted nominal exchange rate is an average of the value of the Australian dollar against Australia’s twenty largest trading partners. 2 (a) Suppose Greece had its own currency, say the Drachma, and a flexible exchange rate. Describe what would have happened to the exchange rate when the real size of the government debt was revealed? What effect would this change in the exchange rate have upon the real economy in Greece? (b) Greece is a member of the Eurozone. What effect upon the Euro did revealing the size of government debt have upon the value of the Euro? What effect would this change in the exchange rate have upon the real economy in Greece? (c) What do you think were the costs for Greece of joining the Euorzone, and what do you think have been the benefits?

Answer 1

Solution

2.(a) Suppose Greece has its own currency (say) Drachma and a flexible exchange rate then :

When the real size of the government debt is revealed,then the Drachma would depreciate relatively to all the currencies across the world.

It is because the higher government debt means higher fiscal deficit which may lead to higher current account balance.So,rating agencies will derate the country as an indication of the increased sovereign risk the country has.So,ultimately the investment flow into the country decrease as the soverign risk has increased.So,the demand for Drachma currency in the global currency exchange market will decrease,so it depreciates w.r.t tother curencies.

(b) Since Greece is a memer of European Union and it's currency is Euro just like the other currencies,this will affect the Euro Zone as a whole.The value of Euro will loose some of it's value : in other words,the Euro will depreciate.

So due to deprecaition of Euro,all the EU members including the Greece will suffer.When a currency depreciates,the imports become costly for that country and exports from that country become cheaper for other countries.The loans that the country has taken from other countries will become costlier since they have to pay more towards the interest than before as it's currency has lost value than before.The country becomes cheaper destination for international tourist to travel into.At the same time that country's tourists travelling to other countries will decrease.

Foreign institutional investments might reduce because the returns that they might have earned in the country will become low since that country's currency is depreciating.( Reason : They invest in that country's currency but when they want to redeem their investments,they need to convert them back other currencies)

(c) Benefits for Greece : Had Greece not joined the Euro Zone it would have got impacted by this kind of  increased govt. debt in a more drastic manner.In other words it would have more drastically impacted in terms of higher amount of it's currency depreciation.Since it is part of Euro Zone and using common currency (Euro) this negative impact fell on entire Euro Zone members as a whole (in the form of Euro depreciation).This effect is way less than had it not joined the EU.This is because there are good performers in the EU like the Germany,UK,etc.due to which this drastic negative effect of Greece got balanced out (atleast to some extent)

It also got some benefits like bailout packages from the other members of the EU

Costs: The other members of the EU since they got negatively affected by Greece,placed austerity measures on Greece.Thriough these measures they placed several strict measures on Greece like cutting public expenditure,prodposing them to increase tax rates for their citizens),more financial transparency like strict accounting etc.,So Greece has lost some of it's freedom than before when it comes to making some choices