GMP Batch 2017

MODEL QUESTIONS
Q.1(10 marks)

Q1.1 Explain briefly the current macro-economic developments in the euro area in terms of economic
growth, unemployment and Inflation. What is the medium term outlook on these three macro-economic
indicators? ( 3 marks)

GDP growth is expected to remain fairly steady in the euro area at 1.6% in 2017 and 1.8% in
2018.Private consumption, the main source of growth so far, is set to slow down as consumer
prices rise and dampen real disposable income growth.
It should, however, continue to benefit from rising employment, though to a lesser extent than
in 2016. Investment growth is projected to remain moderate. On the one hand, investment
should benefit from many favourable determinants including strengthening global activity, high
capacity utilisation and policy support (e.g. low financing costs and the Investment Plan for
Europe). However, a number of hindrances will remain, such as the high level of corporate and
household debt in some Member States, the moderate demand outlook in Europe, and the high
level of uncertainty.
As regards trade, the expected pick-up in emerging market economies, and some advanced
economies, should raise foreign demand for euro area exports. Although declining, growth
differentials across euro area Member States remain large and the increase in benchmark yields
and the USD appreciation could exacerbate these growth differences again.
Unemployment in the euro area is forecast to fall further to 9.1% in 2018. Oil prices are
expected to drive headline inflation in the euro area to 1.7% in 2017 but inflation is expected to
drop back slightly to 1.4% in 2018. Core inflation is projected to slightly increase and stand at
1.4% in 2018. SOURCE: FEB 2017 EC report
The cyclical recovery is firming and becoming broad based. Lower energy prices, supportive
policies, stronger labor markets and a recovery in credit growth have boosted domestic
demand, especially private consumption.
The near-term outlook is favorable, with growth of 1.9 per cent expected in 2017 and 1.7
percent in 2018.
While headline inflation picked up in the first half of 2017 due to higher energy prices, core
inflation has remained persistently low. As the base effect of higher energy prices dissipates,
headline inflation is anticipated to slow from 1.6 per cent this year to 1.5 per cent in 2018, well
below the ECBs medium-term price stability objective.
On current trends, the output gap is forecast to close by 2019. Over the medium term, growth is
expected to stay around 1.5 per cent per annum.
Unemployment is falling amid solid job creation, although it remains elevated in some countries.
Productivity growth has been lagging in some countries, leading convergence across countries to
stall and competitiveness gaps to persist. While the recovery has been resilient to shocks so far, risks
remain and continued monetary policy support is required.

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Q 1.2 What is your assessment of the economic and labour market impact and risks of surge in refugees
in Euro area?( 2 marks)
renewed surge in refugee or migrant inflows could trigger border controls, curtailing the
free movement of people and goods within the EU.
Any disruption of economic activity within the euro area would have important negative spillover
effects on the global economy.
In the short term, the macroeconomic effect from the refugee surge is likely to be a modest increase in
GDP growth, reflecting the fiscal expansion associated with support to the asylum seekers, as well as the
expansion in labor supply as the newcomers begin to enter the labor force. The effect is concentrated in
the main destination countries (Austria, Germany, and Sweden). The impact of the refugees on medium
and long-term growth depends on how they will be integrated in the labor market. International
experience with economic immigrants suggests that migrants have lower employment rates and wages
than natives, though these differences diminish over time. Slow integration reflects factors such as lack
of language skills and transferable job qualifications, as well as barriers to job search. In the case of
refugees, legal constraints on work during the asylum application period also play a role. Factors that
make it difficult for all low-skilled workers to take up jobs, such as high entry wages and other labor
market rigidities, may also be important, as may be welfare traps created by the interaction of social
benefits and the tax system. Reducing restrictions on their geographical mobility (including those linked
to housing) would allow them to move to where labor demand is high. While this can raise legitimate
concerns among native workers that they will face lower wages and higher unemployment, past
experience indicates that any such adverse effects are limited and temporary.

In the short term, additional public spending for the provision of first reception and support services to
asylum seekers, such as housing, food, health and education, will increase aggregate demand. The fiscal
expansion will together with supportive monetary policyhelp compensate for possible downward
pressures on wages and inflation associated with the gradual entry of refugees into employment (see
below). In the medium and long run, the impact of the refugees on employment and GDP will depend on
the speed of their integration in the labor market, the extent to which the newcomers skills will
complement or substitute those of the native labor force, and their impact on the allocation of
resources, product mix, and production technology.

Q1.3 Explain two main areas of structural reforms that are needed for euro area to move to higher
trajectory of potential growth. ( 2 marks).

Accelerate structural reforms to spur investment, productivity

and competitiveness, advance rebalancing. r bank, corporate,
and household balance sheets to enhance monetary
transmission.
Use fiscal space within SGP framework and fiscal rebalancing to
support demand and promote structural reforms. In an adverse
scenario, invoke systemic escape clause in SGP to provide nearterm
demand support while strengthening medium-term fiscal
commitments.

High public debt

Despite the recovery, a number of euro area countriesnot least, Greece, Italy, and Portugalare still
saddled with high public debt. These countries have limited buffers to cushion against economic shocks,

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and could face higher borrowing costs when the current monetary stimulus is gradually reduced,
through lower bond purchases by the European Central Bank, for example. These countries need to
rebuild buffers now and put their public debt-to-GDP ratios solidly on a downward path.

Income promise unfulfilled

The euro area also suffers from a deeper-rooted challenge: a lack of convergence between countries in
income levels per person. In the 12 original euro area members, the catch-up in income levels across
countries has stalled since the adoption of the euro. Contrary to expectations, the lower-income
countries have not grown faster than the higher-income countries in the group. It calls into question the
promise of higher incomes through deeper economic integration, which was one of the original
motivations for the monetary union. This lack of convergence is closely linked to slower productivity
growth in countries with lower initial income levels. At the same time, the gaps in underlying
competitiveness between some of these countries widened in the years after the euro was adopted. In
some countries, wages grew faster than productivity, and this was typically associated with trade
deficits and rising levels of external debt. Some countriessuch as Greece, Portugal, and Spainthen
made painful post-crisis lay-offs, which had the effect of raising output per worker and helped improve
their competitiveness.

But these countries need to do more to fully repair the pre-crisis erosion of competitiveness. Efforts now
should not focus on job cuts, but rather on improving productivity through investment and more
efficient working practices, for example, and reforming their wage bargaining mechanisms. In addition
to the restoration of competitiveness, such steps would raise employment and, ultimately, improve
living standards.

Structural reforms describes a pragmatic policy agenda to raise long-term growth and accelerate
adjustment to shocks, which is essential for countries in a monetary union.
Labor and product market reforms tend to boost productivity more in countries with low productivity
levels and can therefore help reduce productivity gaps, contributing to income convergence. Focusing
just on the labour market, a number of countries have implemented reforms in recent years which have
helped to reduce unemployment most visibly Spain and Portugal, but also Italy. [2] These reforms also
seem to have made unemployment more responsive to growth.[3]

Structural policies are a main factor explaining these positive developments. But of course supportive
financial and macroeconomic policies have been vital, too.
New research also finds that labour market reforms in the euro area reduce the dispersion of
unemployment and GDP across member countries following a common shock, making the single
monetary policy more effective for everyone.[4]
But it is clear that, to get the best results, there has to be some broad coordination among countries.
Labour market reforms can emphasise more wage adjustment or more employment adjustment, and
countries will only converge in their response to shocks if they have a broadly similar mix. [5]
potential growth in the euro area is low after years of decline, while structural unemployment remains
high. The European Commission estimates that the potential growth rate of the euro area economy this
year is just 1%, half that of the United States.[5]
Low potential growth casts a shadow over the long-run economic prospects for the euro area, creating a
negative feedback loop. Because low potential growth dampens expectations of future income, it curbs

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consumption and investment today, which further lowers rates of potential growth tomorrow. This can
lead to a permanent destruction of productive capacity, including jobs.[6]
It is therefore imperative that decisive action is taken now in order to propel the on-going cyclical
recovery into a structural recovery. Long-run growth depends on the efficiency with which resources are
allocated, the ease of doing business, the incentives for investment and confidence in public institutions.
Making strides in these areas requires structural reforms aimed at supporting investment, enhancing
productivity and increasing flexibility in the markets for labour, goods and services. Structural reforms
will go a long way, not only in bolstering the trend of long-run growth but also in reducing the
fluctuations around that trend.[7]

Such reforms are the means of addressing the ongoing adjustment difficulties faced by the economy and
of preventing secular stagnation which is not inevitable. However, such reforms are outside of the
scope of monetary policy and fall under the remit of other national and European policymakers.

As the benefits of structural reforms can take time to materialise, they must be implemented without
undue delay and are needed in order to reap the full benefits from our monetary policy measures. The
highly accommodative stance of monetary policy creates ideal conditions for the implementation of
structural policies, as it can help to cushion the potential short-term adjustment costs of such policies by
supporting current demand conditions.

To conclude, the euro area economic recovery remains resilient despite the continued headwinds
stemming from global economic and political uncertainties. Nevertheless, in order to transform the
cyclical recovery into a structural one, and thereby ensure resilience of growth in the long-run, other
policymakers must play their part. The support to demand from monetary policy must be
complemented with supply policies that bolster the potential growth, productivity and flexibility of the
euro area economy.

Q1.4 Briefly discuss the external sector position in the euro area in terms of current account balance ,
capital flows and real effective exchange rate?( 3 marks)

The regions current account surplus rose to about 3.3 percent of GDP in 2016 (Figure 3). The CPI-
based real effective exchange rate (REER) appreciated by about 1.1 percent over the same period,
consistent with the gradual strengthening of the euro area recovery. As of May 2017, the REER has
depreciated compared to its average level in 2016 by around 1 percent. Overall, the euro areas
external position in 2016 remained broadly in line with the level implied by medium-term
fundamentals and desirable policies .
The current account (CA) balance for the euro area was higher at 3.3 percent of GDP (cyclically adjusted
2.9 percent) in 2016. Nearly all euro area countries are now running current account surpluses (apart from
Belgium, Cyprus, Finland, France, Greece,and Lithuania). Although the drivers of the improvements differ
across countries, lower commodity prices have provided a broadbased boost to euro area current
accounts. Import compression in the immediate aftermath of the crisis and external competitiveness
gains from price and wage adjustments have strengthened the current accounts of net external debtors,
like Spain and Portugal. The continued growth of the surpluses of some large creditor countries, such as
Germany and the Netherlands, reflect strong corporate

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and public saving and weak investment.
The CPI-based real effective exchange rate appreciated by about 1.1 percent from 2015 to 2016, reflecting
the gradual strengthening of the euro areas recovery. Weaker inflation in the euro area relative to its
trading partners accounts for a real appreciation lower than the nominal appreciation of about 3.3
percent. As of May 2017, the REER is down by about 1.0 percent relative to its 2016 average level,
essentially unwinding the 2016 appreciation.
Mirroring the 2016 CA surplus, the euro area experienced net capital outflows, largely driven by portfolio
debt and FDI outflows. These were somewhat tempered by inflows into portfolio equity and loans and
other bank-related instruments. The geography of gross capital inflows shifted with the global financial
and sovereign debt crises, with inflows from the core euro area economies into the rest of the euro area
diminishing. Capital outflows in portfolio debt and inflows into portfolio equity over the past couple years
likely arose in large part from the ECBs monetary accommodation through its asset purchase program,
which has lowered yields on debt and spurred interest in equity.

Q2.( 10 marks)

Q2.1 Explain the treaty on fiscal Compact in terms of balanced budget rules.( 3 marks)

The Fiscal part of TSCG (Teaty on Stability, Coordination and Governance in the Economic and
Monetary Union) is referred to as fiscal compact.
Signed by 25 EU members except UK and Czech Republic
Binding on all euro area countries
Countries should respect/ensure country specific medium term objectives( MTOs) as defined in
SGP with a lower limit of a structural deficit ( Cyclical Effects and one off measures are not
taken into account) of 0.5 per cent of GDP
Fiscal Compact takes into account 3% deficit GDP ratio, 60 per cent debt- GDO and structural
deficit of 0.5 per cent as country specific medium term objective( MTOs). Countries with debt
GDP ratio below 60 per cent should have structural deficit of 1 percent. This is otherwise called
National debt brakes or golden rules.
A fine up to 0.1 per cent GDP may be imposed if the golden rule is broken and there is a
complain by a member state in the European Court Of Justice
The 1/20 rule is applied when the country is in Excessive Deficit Procedure( EDP) having more
than 60 % of Debt GDP ratio. This implies annual reduction of 1/20 of debt ratio
If the country does not follow 1/20 rule a fine of 0.2 per cent of GDP is imposed.

Q2.2 What are the fiscal rules under Maastricht treaty? What is Excessive Deficit Procedure? Explain
the concept of Debt brake ( 3 marks)

Maastricht Treaty 1992( MT): 3% fiscal deficit 60% debt( percentage to euro area GDP)
Stability and Growth Pact ( SGP)1997: 3% fiscal deficit and 60 % debt( percentage to euro area
GDP)- called corrective arm and a for medium term budget positions requirement to be balance
or surplus called Preventive arm
The Excessive deficit procedure, abbreviated as EDP, is an action launched by the European
Commission against any European Union (EU) Member State that exceeds the
budgetary deficit ceiling imposed by the EU's Stability and growth pact legislation.
Fiscal Compact takes into account 3% deficit GDP ratio, 60 per cent debt- GDO and structural
deficit of 0.5 per cent as country specific medium term objective( MTOs). Countries with debt
GDP ratio below 60 per cent should have structural deficit of 1 percent. This is otherwise called

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 National debt brakes or golden rules. The debt brake therefore addresses two classical
objectives of fiscal policy: ensuring the sustainability of public finances and smoothing
economic cycle and growth fluctuations.
The criteria adopted by the Treaty are related in particular to exchange rate stability,
convergence of interest rates in the long run, inflation rates and two indicators of public finance:
deficit/GDP and debt/GDP ratios.
Inflation rate. The rate of inflation in the year preceding accession must not be more than 1.5
percentage points above that of the three best-performing member states in terms of price
stability.
The ratio of the government deficit to GDP must not exceed 3% unless:
either the ratio has declined substantially and continuously and reached a level that comes
close to the reference value; or, alternatively,
the excess over the reference value is only exceptional and temporary and the ratio remains
close to the reference value.
The ratio of government debt to GDP must not exceed 60% of GDP, unless the ratio is
sufficiently diminishing and approaching the reference value at a satisfactory pace.
Excessive Deficit Procedure( EDP) which applies to member countries which have breached the
deficit or debt rule. The purpose of the excessive deficit procedure (EDP) is to prevent excessive
deficits and to ensure their prompt correction. According to the amended SGP, an EDP is
triggered by the deficit criterion or the debt criterion:
Deficit criterion: A general government deficit is considered to be excessive if it is higher than
the reference value of 3% of GDP at market prices; or
Debt criterion: debt is higher than 60% of GDP and the annual debt reduction target of 1/20 of
the debt in excess of the 60% threshold has not been achieved over the last three years
The amended regulation also contains provisions clarifying when, if a deficit is higher than the
stated reference value, it will be considered exceptional (resulting from an unusual event or a
severe economic downturn, etc.) or temporary (when forecasts indicate that the deficit will fall
below the reference value following the end of the unusual event or downturn).

Q2.3 As a prospective business manager what is your assessment of the Stability and Growth Pact ?( 4
marks)

The Stability and Growth Pact (SGP) is an agreement, among the 28 Member states of the European
Union, to facilitate and maintain the stability of the Economic and Monetary Union (EMU).
Specifically, each country must maintain an annual budget deficit that is no greater than
3% of GDP, and each must have a national debt that is lower than 60% of GDP. The preventive arm of
the Stability and Growth Pact aims to ensure sound budgetary policies over the medium term by setting
parameters for Member States' fiscal planning and policies during normal economic times, while taking
into account the ups and downs of the economic cycle. The corrective arm of the Stability and Growth
Pact ensures that Member States adopt appropriate policy responses to correct excessive deficits
(and/or debts) by implementing the Excessive Deficit Procedure (EDP).
This is an important pact that ensures that countries do not get caught in a debt spiral where they
overspend, borrow, spend again and have to keep borrowing. When this happens, the European
economy as a whole suffers and markets decline which reduces profits. This is a prudent policy which
ensures that countries think about the long term future and dont spend for public appeasement and

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votes. This pact ensures that European markets stay healthy and are not propped up by debts which in
the long run cripple the economy of a country.

Q3. ( 10 marks)

Q3.1 Explain the objective of monetary policy in Euro area? What is the quantitative target of Price
stability? ( 2 mark)

Maastricht Treaty through monetary policy gives absolute priority to the objective of price stability.

ECB has adopted a specific strategy to ensure the successful conduct of monetary policy. It has defined
price stability as a year-on-year increase of below 2% in the Harmonised Index of Consumer Prices
(HICP) for euro area.
In the pursuit of price stability, ECB aims at maintaining inflation rates below, but close to, 2% over the
medium term.

Q 3.2 Discuss briefly what you have learnt on the monetary policy instruments used by ECB?( 3 marks)

Following are the set of monetary policy instruments used by ECB:

1. Open Market Operations

Open market operations play an important role in steering interest rates, managing the liquidity
situation in the market and signaling the monetary policy stance.

Following five types of financial instruments are available to the Eurosystem for its open market
operations:
i. Reverse transaction
ii. Main refinancing
iii. Longer-term refinancing operations
iv. Fine-tuning operations
v. Structural operations

2. Standing Facilities

The Eurosystem offers credit institutions two standing facilities:

i. Marginal lending facility in order to obtain overnight liquidity from the central bank
against presentation of sufficient eligible assets. The interest rate on the marginal
lending facility normally provides a ceiling for the overnight market interest rate.

ii. Deposit facility in order to make overnight deposits with the central bank. The interest
rate on the deposit facility normally provides a floor for the overnight market interest
rate.

3. Minimum Reserve Requirements for Credit Institutions

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 Minimum reserves are an integral part of the operational framework for the monetary policy in euro
area.
The intent of the minimum reserve system is to pursue the aim of stabilizing money market interest
rates, creating/ enlarging structural liquidity shortage and possibly contributing to the control of
monetary expansion.
The ECB requires credit institutions established in euro area to hold deposits on accounts with their
national central bank called minimum or required reserves (MMR).

The reserve requirement of each institution is determined in relation to elements of its balance
sheet. This implies that compliance with the reserve requirement is determined on the basis of the
institutions' average daily reserve holdings over a maintenance period of about one month. The
reserve maintenance periods start on the settlement day of the main refinancing operation (MRO)
following the Governing Council meeting at which the monthly assessment of the monetary policy
stance is pre-scheduled. The required reserve holdings are remunerated at a level corresponding to
the average interest rate over the maintenance period of the main refinancing operations of the
Eurosystem. {EXTRA INFORMATION}

4. In addition, since 2009, ECB has implemented several unconventional/non-standard monetary

policy measures like Asset Purchase Programs, to complement the regular operations of Euro
system.

Q3.3 What is your assessment as a prospective business manager on the low interest rate in the euro
area?( 3 marks)

The European Central Bank's mandate is to ensure price stability by aiming for an inflation rate of below
but close to 2% over the medium term. Like most central banks, the ECB influences inflation by setting
interest rates. If the central bank wants to act against too high inflation, it generally increases interest
rates, making it more expensive to borrow and more attractive to save. By contrast, if it wants to
counter too low inflation, it reduces interest rates.
Since euro area inflation is expected to remain considerably below 2% for a prolonged period, the ECB's
Governing Council has judged that it needs to lower interest rates. The ECB has three main interest
rates on which it can act: the marginal lending facility for overnight lending to banks, the main
refinancing operations and the deposit facility. The main refinancing rate is the rate at which banks can
regularly borrow from the ECB while the deposit rate is the rate banks receive for funds parked at the
central bank. All three rates have been lowered. To maintain a functioning money market in which
commercial banks lend to each other, these rates cannot be too close to each other. Since the deposit
rate was already at 0% and the refinancing rate at 0.25%, a cut in the refinancing rate to 0.15 % meant
the deposit rate was lowered to 0.10 % to maintain this corridor. The cut is part of a combination of
measures designed to ensure price stability over the medium term, which is a necessary condition for
sustainable growth in the euro area. Weakening global growth and a generally lower natural interest
rate are demanding very low, sometimes negative, market rates so that investment and consumption
become more attractive. In the medium term we are thereby aiming to get inflation back to a level in
line with our mandate to ensure price stability of below, but close to, 2%.
Without our measures, the euro area economy would probably have slipped back into recession, with
the risk of fully fledged deflation. We had to act and have prevented things from getting worse. Our
measures have proved effective.

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The mandate is clear. It says that in the medium term EU has to achieve an inflation rate of below, but
close to, 2%. This is the only goal that the unconventional measures are also bound by. And price
stability is an exclusively internal objective the ECB does not pursue an exchange rate policy.
Nevertheless, the longer it takes to achieve this goal, the greater the risk that the side effects of ECBs
measures become stronger, especially of the negative rates. While we are doing what we can to keep
the side effects to a minimum, the financial industry must play its part and adapt as far as possible.
The recovery has started. However, for it to be sustainable, ECB must first and foremost address the
causes of this global low interest rate environment. But monetary policy cannot manage this on its own
not least because their measures are not intended to become a permanent feature of the system.
The economic recovery cannot be sustained by monetary policy alone
Its a great time to borrow and invest since the costs associated with it are low. Europe currently wants
more growth and for that they need spending. To encourage spending the rates have been kept low. As
a manager I will take on a loan at low int rates and invest them in avenues which could lead to higher
revenues.

Q3.4 Discuss briefly the unconventional monetary policy followed by ECB in terms of asset purchases.( 2
marks)

The expanded Asset Purchase Program (APP) adds the purchase program for public sector securities to
the existing private sector asset purchase program to address the risks of a prolonged period of low
inflation.
It consists of:
Third covered bond purchase program (CBPP3)
Asset-backed securities purchase program (ABSPP)
Public sector purchase program (PSPP)

To ease credit and financing conditions for firms and households, in recent years the ECB has taken a
number of unconventional (non-standard) monetary policy measures.
These measures include the provision of liquidity through the direct purchase of private and
government assets (direct quantitative easing), the purchase of commercial paper, corporate bonds and
asset-backed securities to address liquidity shortages and spreads in certain market segments (direct
credit easing), the flattening of the yield curve by lending to banks at longer maturities (indirect
quantitative/credit easing) and, finally, the commitment to keep long interest rates low over an
extended period (forward guidance). {EXTRA INFORMATION}

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