Suppose that the Greek economy is experiencing a recession

9 05 2010

It’s been long since I wanted to comment on the fiscal problems of Greece but could not do so because of lots of work. I will start with this little excerpt from the answers provided to questions in an Economics textbook. The book is Macroeconomics, by N. Gregory Mankiw, Harvard University and Mark P Taylor, University of Warwick. It is published by Cengage Learning EMEA in 2007. Here’s the piece:

2. Suppose that the German economy is experiencing a recession while other countries in the Eurozone are in long-run macroeconomic equilibrium.
a. What would happen to interest rates on long-term government bonds issued by Eurozone governments if the German government were to increase its budget deficit dramatically to finance additional government spending? Explain your answer.
Interest rates on Eurozone government bonds would rise. A dramatic increase in the German government’s budget deficit would increase the risk of holding German government debt and so the financial markets would demand a higher rate of return for holding this debt. Because the other Eurozone governments would be expected to assist the German government in the event that it ran into difficulty in meeting its obligations to its creditors, so transmitting some of the increased risk to them, the financial markets would not demand as a high a return on German government bonds as would otherwise be the case. (There would be a free rider problem.) The markets would also demand a higher rate of return for holding the bonds of other Eurozone governments too.
b. What might the members of a currency union do to counter this problem?
They might agree limits on the size of the budget deficits that member governments would be permitted to run.
c. What might reduce the need for the German government to increase its
budget deficit in these circumstances?
Increased labour mobility and increased real wage flexibility, which would act to prevent unemployment rising so high in Germany when aggregate demand was depressed. The Eurozone countries could also agree to operate a Eurozone-wide fiscal policy so that additional government spending in recession-hit Germany could be financed by tax revenues raised from across the Eurozone.

Anyone said we did not know what will happen? And indeed, anyone said that studying economics does not make sense? So the Germans new very well what they should do. They just didn’t want to do it. I can understand this, it’s paying back with the same coin of distrust and treason. But that makes all of them traitors of the idea. It’s the politicians’ meddling that once again blocked the solution. You can find the excerpt here and the book here.




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