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Problems in Euro Land
Subject Economic Growth
Topic International Finance
Key Words Economic Growth, Unemployment, Interest Rates, Monetary Policy
News Story

Economic problems seem to be everywhere. Japan is trying to combat deflation and recession, the U.S. is coping with a slow recovery, Argentina is recovering from a default and devaluation, other South America countries are in recession, but Europe appears to be one of the weakest regional economies at this time. Euro zone economic growth was an annualized 1.2 percent for the third quarter about one-third of the U.S. rate. Germany, the leading economy in the European Union (EU) shows no sign of recovery and unemployment hit 10 percent in November. The European Central Bank is expected to lower interest rates in order to stimulate the EU economy.

One of the problems that the EU is experiencing is a lack of flexibility in labor and product markets. When demand falls, firms are not likely to cut costs by reducing employment or wages, nor are they able to lower prices. Firms faced with decreased revenues and stubborn costs are more likely to go bankrupt, as they are doing in record numbers in Germany. Because prices are not likely to decrease, inflation, currently at 2.2 percent, is above the European Central Bank's price-stability target; the central bank has been reluctant to lower interest rates in an effort to stimulate the economy. In spite of growing unemployment and meager growth, interest rates have not changed in a year.

While monetary policy has been slow to react, fiscal policy has also had its problems. EU rules limit budget deficits and, therefore, mitigate euro governments from applying economic stimulus. In contrast, over the last two years, the Bush Administration has spent about 3 percent of GDP for tax cuts and increased government spending, one of the largest expansions in over 50 years.


(Updated February 5, 2003)

Questions
1.

Using aggregate demand/aggregate supply diagrams illustrate an economy with an recessionary gap. Illustrate how an increase in the rate of interest will affect the gap. What effect will it have on the rate of inflation?

2. Long-term unemployment appears to be a significant problem in Germany. How would a decrease in the rate of interest affect Germany's unemployment rate?
3. What happens to Germany's budget deficit in the short run if it decides to stimulate the economy through tax cuts? What might happen over a year or two?
Source Christopher Rhoads, "Euro Zone Grew By Anemic 1.2% In Third Quarter," The Wall Street Journal, December 5, 2002.

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