Greece is a European country whose currency is the euro (€). Greece’s government has been borrowing because of its large budget deficits. There is widespread fear that Greece will be unable to repay the people and institutions that have lent it money. This is being called the “Greek Debt Crisis.” a. Wealth holders around the world reacted to the Greek Debt Crisis by selling European financial assets and buying U.S. financial assets. Explain why their action changed the exchange rate between euros and dollars. Did their action strengthen or weaken the dollar relative to the euro? b. Greece is part of the “Eurozone” – 16 countries that each use the euro (€) as its currency. The European Central Bank (ECB) sets monetary policy for the Eurozone. (You can think of the ECB as “Europe’s Fed.”) One monetary policy applies to all 16 countries of the Eurozone. The Greek legislature approved “austerity measures”: • increased taxes • reduced pensions (the equivalent of our Social Security), and • reduced pay for government workers. The austerity measures described above will increase Greek unemployment. Explain why? If the ECB wanted to use interest rates to help Greece’s economy following imposition of the austerity measures, should the ECB increase interest rates or decrease interest rates? Why? Explain fully. c. Suppose the ECB takes the action you propose in Question 1b. In Eurozone countries that are currently at or near full employment, what impact will that change in interest rates have on inflation? Explain.
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