Question

In: Economics

The EU Central Bank is worried that with Brexit and decreasing GDP growth rates in Germany...

The EU Central Bank is worried that with Brexit and decreasing GDP growth rates in Germany it will have to take action in 2018. Given that the Central Bank’s risk (i.e. discount) rate is near zero what actions will be taken?

a. Explain the actions you expect the Central Bank to take and explain in macroeconomic measurement, modeling and movement terms what the Central Bank’s actions will have on EU exchange rates and exports with the U.S.

b. Use macro models and macro movement sequences to explain what actions youexpect the FED to take in response to the actions of the EU Central Bank and what movements in U.S. GDP and inflation rates will occur by the end of 2018.

Solutions

Expert Solution

a. The aim of the ECB is to try and revive the European economy in the wake of Brexit. It can do so through the use of a looser monetary policy by increasing the money supply. It can do by undertaking an open market purchase which will release more money supply into the economy. This will cause the LM curve to shift rightwards and hence increase the level of output and reduce the interest rates within the EU. The ECB can also relax the reserve requirements for banks in the European union and this allows greater fund flow. This will allow greater liquidity and so enhances the growth rate in the EU. These measures will mean that interest rates will fall and so make the euro cheaper. This will cause an increase in EU exports and and a fall in US imports that seem more expensive. The balance of trade in the EU will thus improve.

b. The Fed will be mindful that the US balance of trade will now deteriorate as the US dollar appreciates relatively. The Fed will thus use a expansionery monetary policy of its own and try and cut interest rates to bring down the value of the dollar relatively. This will cause the LM curve in the US to also shift rightwards thus increasing liquidity and levels of GDP in the economy. The results will be that the inflation rates in the US will go up as money supply circulates across the economy.


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