David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

Summary
lower imports shift the IS1 curve to the right. If wage and
price flexibility is high enough, there may be no need for
fiscal policy. However, many European labour markets are
quite sluggish. Sensible use of fiscal policy may speed up
the process.
One final point. If there is no discretionary change in tax
rates and spending levels, fiscal relaxation in a recession
is limited to the automatic stabilizers. However, these cannot
see into the future. Only after income falls is revenue from
income tax reduced. In 2001 Europe was hit by two
demand shocks: the US recession as the dotcom bubble
burst and the confidence collapse after 11 September.
Because the real economy is sluggish, it took time for these
to feed through into lower output, lower employment and
lower inflation. But by 12 September everyone knew these
were coming. Ideally, demand policies should have been
eased to offset these demand shocks. If fiscal policy is
largely confined to backward-looking automatic stabilizers,
the only channel for a forward-looking policy response is
through interest rate cuts.
Hence, the fiscal framework in the EMU raises the burden
on monetary policy to react to shocks even before they
have fed fully through into output and inflation.
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Yo
Y, Y0
Output
LM
A small EMU member faces a horizontal LM curve at
the interest rate set by the ECB. If the IS curve shifts
to IS,, interest rates will be reduced only if the whole
of EMU is affected by the shock. Otherwise, the
country faces a slump that gradually reduces its prices
and wages, boosting competitiveness and shifting IS,
to the right. A fiscal expansion could induce this shift
more quickly.
Figure 29.3
A member of the eurozone
Summary
• Under the gold standard, each country fixed the par value of its currency against gold, maintained the
convertibility of its currency into gold at this price and linked the domestic money supply to gold
stocks at the central bank. It was a fixed exchange rate regime.
• Without capital flows, countries with a trade deficit faced a payments deficit, lower gold stocks and a
lower money supply. Domestic recession then bid down wages and prices, raising competitiveness - an
automatic adjustment mechanism. Trade surplus countries faced a monetary inflow, higher prices and
lower competitiveness. In practice, this adjustment mechanism was hampered by capital flows.
• The post-war Bretton Woods system was an adjustable peg in which fixed exchange rates were
sometimes adjusted. It was a dollar standard. But domestic money supplies were no longer linked to
forex reserves, so the adjustment mechanism of the gold standard was weakened.
• Purchasing power parity (PPP) is the path of the nominal exchange rate that would maintain constant
competitiveness by offsetting differential inflation across countries. In the long run, floating exchange
rates return to the PPP path if no real shocks occur.
• In the short run, the level of floating exchange rates is determined largely by speculation. Exchange
rates adjust to ensure interest differentials are offset by expected exchange rate changes. This chokes
off large speculative flows. In the short run, exchange rates can depart significantly from their long-run
level.
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