Question

Faced with high levels of government debt, European Union economies have been reducing government expenditure and/or raising taxes. What are the effects of these “austerity policies” on EU national saving, S? For each of the following three cases, derive the expected effects on EU and US interest rates, saving, investment, and net exports: (a) EU is a closed economy; (b) EU is a small open economy; (c) the world consists of two large economies: the EU and the US.

Answer 1

The harsh austerity measures that, according to official policy, are supposed to overcome the euro crisis have once again plunged Europe into recession in 2012. Austerity policy has proved – in Greece, Italy, Portugal and Spain (GIPS) – to be primarily an attack on wages, social services and public ownership. The EU has developed a new form of wage policy interventionism (Euro Plus Pact, Six Pack). The principles of centralised collective agreements and general applicability are being undermined in the GIPS states and collective bargaining systems are being decentralised. Real wages fell in these four states from 2010 to 2012 at an above-average rate. As regards pension policy the GIPS states have introduced reforms that significantly curtail spending growth in pension systems. Relative pension levels will fall dramatically in these states up to 2040, measured in terms of the wage replacement rate. Due to the euro crisis the policy of privatising public assets in the GIPS states has been given new impetus. Greece has been hardest hit and is planning a veritable fire sale of state property. The abovementioned interventions in Southern Europe mean that the liberalisation of the European Social Model – which up until the crisis was to be observed mainly in western and eastern Europe – will be implemented in the EU as a whole. If the path of economic austerity, despite all opposition, is maintained until 2014/2015 and then experiences a new upswing the policy disaster for European social democracy and the trade unions will be complete.

a) EU is a closed economy: In a closed economy (EU), national savings is the sum of private saving and the public saving.

The rate of interest is determined as in a closed economy according to the requirements of the asset market equilibrium that is through demand and supply of assets including money.It is detennined conjunctly with income by both stock and flow decisions involving the 'liquidity preference' schedule2 , the given stock of money, consumption function and the marginal efficiency of capital schedule. That is, the two variables i and y are determined by two equations such as: M=L (i, Y) and I (i) =sY

A closed economy is one that does not interact with other economies. A closed economy does not engage in international trade in goods and services. Therefore net exports (NX) are also zero

The below equation states that saving equals investment in a closed economy.

S=I

b) EU is a small open economy: In an open economy (EU), national saving is the sum of private savings, the public saving, and net capital inflows.

The usual assumption is that domestic rate of interest is detennined by market forces whereas the foreign rate of interest is assumed to be given. That is, for a small open economy, the domestic rate of interest is set by the given world rate of interest. With the trade in marketable financial assets, portfolio choice includes foreign assets including money apart from domestic assets.

The assumption of perfect capital mobility, together with the very strong assumption of a perfect equilibrium, causes the interest rate in the small open economy, r, to equal the world interest rate r*, the real interest rate prevailing in world financial markets: r = r*.

This means that people in this small open economy will never borrow at more than rate r in the small open economy. They will shift to international markets to borrow or invest, in case r > r*. Because of the popularity of the small open economy model, it is often said that, the interest rates in a small open economy are determined by the world markets. The world interest rate is determined in another way, and often economists choose to model this through an equilibrium between world interest and world savings.

In a small open economy, investment (capital) flows in and out of a country freely at a fixed world interest rate.

Net export is the difference between total output (Y) and total spending (C+I+G) If output exceeds the total spending, we export the difference, and NX is positive (trade surplus). If output falls short of spending, we import the difference and NX is negative (trade deficit).

c) The world consists of two large economies: the EU and the US.: In large open economies, a rise in domestic saving 1) raises the trade surplus and net capital outflows in the domestic economy, 2) raises the trade deficit and capital inflows in the rest of the world, 3) raises investment in both the domestic economy and the rest of the world, and 4) lowers world interest rates.

An increase in domestic desired investment lowers the trade surplus and net capital outflows in the domestic economy, lowers the trade deficit and capital inflows in the rest of the world, raises world interest rates, and lowers investment in the rest of the world.

In developed/large economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.

Exports facilitate international trade and stimulate domestic economic activity by creating employment, production, and revenues. Its play an important role in the economy, influencing the level of economic growth, employment and the balance of payments.In the post-war period, lower transport costs, globalisation, economies of scale and reduced tariff barriers have all helped exports become a bigger share of national income.