Reference no: EM135414

The European Central Bank (ECB) surprised markets with a rate cut Thursday (Nov 7th) and economists recommend that it might not be done.

The ECB unexpectedly cut rates by 25 basis points today to a record-low of 0.25%. BMO Capital Markets notes that ECB president, Mario Draghi, stated that Thursday's rate cut reflects the fact that the bank now expects "a prolonged period of low inflation".

Scotia Economics states that the rate cut, "Points out that the increased risk of sustained low inflation has become a concern for euro area monetary authorities in view of a recovery that remains ‘weak, uneven and fragile."

And, in the wake of this surprise cut, economists are expecting rates to stay low for a long time. "With the Euro Area economy likely facing a prolonged period of weak growth and inflation, policy rates look to stay exceptionally low for a very long time," BMO says.
However, BMO reports that the ECB confirmed that monetary policy will stay accommodative for as long as essential. In fact, it states that Draghi reiterated that even lower rates are possible.

Scotia states that the likelihood of a further liquidity injection in the near term is low. Though, it as well warns that the upcoming asset quality review and stress test of euro area banks "have the potential to introduce a new round of financial market volatility and political uncertainty, which could necessitate additional policy action."

In light of this article, and the events it explains, answer the given questions. Suppose that the economy of the Euro-countries is a closed economy.

a) Suppose European Central Bank (ECB) uses open market operations to undertake this change. Explain in brief the actions the ECB must do in the open market in order to pull this off.

b) Draw one IS/LM diagram which depicts the initial equilibrium of the Euro-economy before this intervention and the new equilibrium after this intervention. In brief describe words why the initial equilibrium has been placed where you drew it.

c) Describe the impact of this intervention on the unemployment rate, the level of investment, real output in the short-run. In words, describe what assumptions you have used for expected inflation prior to this intervention and immediately after it. Describe why you feel these suppositions (about expected inflation) are reasonable.

d) The article referred stated "The ECB unexpectedly cut rates ..." in essence saying this intervention was "unexpected". Would this intervention have a different effect on the Euro-area economy if it was "expected"? If so, describe why an expected intervention would be different than an unexpected one. Also, describe how, if at all, these two different kinds of interventions would differ in terms of their economic impacts on real output, employment, the real interest rate, consumption, investment and real money balances.

e) The article as well stated "... the upcoming asset quality review and stress test of euro area banks "have the potential to introduce a new round of financial market volatility and political uncertainty, which could necessitate additional policy action." By using words and one NEW IS-LM diagram elucidate what sort of financial market volatility they probably speaking of and how this volatility would impact the real economy in the short-run (in terms of its' impact on real output, the real interest rate, unemployment, consumption and real money balances). As well, when the article mentions that such volatility could necessitate additional policy action what "policy action" are they probably refereeing to? Draw the impact of such policy action in your NEW diagram (label your curves with subscripts equal to "1" for curves prior to the financial market volatility, "2" for curves after the volatility, and "3" for curves after the policy action).