South-Western College Publishing - Economics  
Continental Drift
Subject Monetary Policy
Topic International Finance
Key Words Economic Growth, Economic Reform, Inflation, Unemployment
News Story

Although many had hoped that the launch of the euro would launch a new era of European competitiveness and economic growth, the initial results appear to be disappointing. Continental Europe's economies are slowing, business confidence is slipping and the euro is soft. Europe's growth dimmed further with the Bank of England's forecast that the United Kingdom's economy would expand by only .5 percent. In spite of the growth slowdown, the European Central Bank appears reluctant to lower interest rates. The Bank argues that economic reform is needed, rather than lower interest rates.

European growth is expected to be around 2 percent, significantly less than the 5.6 percent growth reported by the United States in the 4th quarter. However, the European Central Bank believes that lowering interest rates to stimulate growth below the current 3 percent level would rekindle inflation. Some believe that the recent drop in the euro -- down nearly 5 percent against the dollar since its January 1 start -- should provide as much additional stimulus as a 1 percent decrease in the interest rate.

In theory, a drop in the euro should spur exports since a weaker euro makes European exports relatively cheaper. However, European Union countries do most of their trading with each other and are therefore protected against currency fluctuations. Sales to countries outside of the euro-zone amount to only 15 percent of output, and so exports are not a major source of growth.

Inflation in the euro countries is low and decreasing, but unemployment remains high. While economic restructuring, including reducing labor market rigidities and economic reforms, could result in lowered unemployment, euro-zone leaders have not as yet proposed any such measures.

(Updated March 1, 1999)

Questions
1. What would be the likely consequences of lower interest rates in the 11 European countries that comprise the euro-zone?
2. Why would European Central Bank leaders fear that a reduction in interest rates could rekindle inflation?
3. How would easing labor market rigidities lower the unemployment rate?
Source Sylvia Ascarelli and G. Pascal Zachary, "Europe's Economic Outlook Dims With Britain's; Rate Cuts on Continent Appear Unlikely", The Wall Street Journal, February 11, 1999

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