End of the upswing in Euroland: No reason to cut interest rates
Economic expansion in Euroland has decelerated considerably after mid-2000 as a consequence of the weakening of growth in the world economy, the tightening of monetary policy by the European Central Bank as well as the burden imposed by higher oil prices. While the upswing in the euro area has come to an end, there is no reason to dramatize the current situation. It has to be kept in mind that economy-wide capacity utilization has already risen to its normal level, and it is not likely that real GDP will fall below potential output. The government budget of euro-area countries showed a surplus in 2000 for the first time since the 1960s. This year and next year the euro-area budget will change into a deficit also because taxes had been cut in a number of countries. It has to be criticized that consolidation efforts have ceased; in particular Germany, France, and Italy are still far away from a balanced budget. There is a risk that these countries will not meet their targets; the stability and growth programs are somewhat unrealistic because governments expect that higher trend growth than in the past will solve the problem. Many observers have urged the ECB to follow the example of the Fed and cut interest rates in order to prevent a sharp drop in economic activity. But in our view the ECB neither should nor will alter its course. First of all the current stance of monetary policy is not restrictive; according to the Taylor rule, short-term interest rates are even too low. Moreover, the growth of M3 will not fall below the reference value. Finally, the projections presented by the ECB last December do not justify a cut in interest rates. In the medium run, the expansion of the money stock is the most important factor for inflation, while in the short run inflation is also influenced by other factors. These considerations underlie the P-star model in which the development of inflation depends on the liquidity overhang, defined as price gap, as well as on cost factors. This model can explain the past movements of inflation quite well. As regards the inflation forecast it is important to note that the price gap has closed due to a rise in the price level and the slower increase in M3 in the past months. Consequently, we expect that the increase in consumer prices will gradually slow in 2001 and 2002. Recently, the Irish government has been criticized by the Council of European finance ministers for its fiscal policy. This came as a surprise in view of the excellent situation of public finances in Ireland. The critique aimed at the loosening of fiscal policy which would aggravate the bottlenecks in the economy. But it is also questionable whether a fiscal contraction in Ireland would be the appropriate response. All in all, the only way to cool down the economy seems to be an acceleration of wage growth and inflation and the implied real appreciation of the Irish pound.
|Date of creation:||2001|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: +49 431 8814-1
Fax: +49 431 8814528
Web page: http://www.ifw-kiel.de/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Joachim Scheide & Mathias Trabandt, 2000. "Predicting Inflation in Euroland ; The Pstar Approach," Kiel Working Papers 1019, Kiel Institute for the World Economy.
- Clarida, R. & Gali, J. & Gertler, M., 1999.
"The Science of Monetary Policy: A New Keynesian Perspective,"
99-13, C.V. Starr Center for Applied Economics, New York University.
- Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
- Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
- Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
- Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
- Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-58, September.
- FitzGerald, John, 2001. "Fiscal Policy in a Monetary Union: The Case of Ireland," Quarterly Economic Commentary: Special Articles, Economic and Social Research Institute (ESRI), vol. 2001(1-March), pages 1-17.
- Karl-Heinz Tödter & Hans-Eggert Reimers, 1994. "P-Star as a link between money and prices in Germany," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 130(2), pages 273-289, June.
When requesting a correction, please mention this item's handle: RePEc:zbw:ifwkdp:374. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (ZBW - German National Library of Economics)
If references are entirely missing, you can add them using this form.