Question

If a country such as Greece that has joined the European Monetary Union can no longer use an independent monetary policy to offset a recession, what sorts of fiscal policy initiatives might it undertake? Give at least two examples.

Short answer

A higher weightage is given to various local business cycles when setting monetary policy and interest rates, which precludes the independent monetary policy of Greece.

Greece can make "internal adjustments" like lowering tax rates and implementing recession-induced deflation as remedial measures to overcome such a situation.

Step-by-step solution

Independent monetary policy loss

A shared currency precludes independent monetary policies and external adjustments.

When a group of countries uses different currencies, international trade is hampered by currency-conversion fees, exchange-rate risk, and the difficulties faced by shoppers when prices are quoted in multiple currencies.

When Greece joined the European Monetary Union, it retained its central bank but ceded control over monetary policy to the central authority of the European Central Bank (ECB). This is because suppose that Greece is in a recession while the rest of Europe is booming. The European Central Bank has to set a single policy for all members as a majority have booming economies. As such, the ECB will choose to either keep interest rates constant or even raise them—just the opposite of what recessionary Greece needs.

Thus, when setting the European Union's monetary policy and interest rates, a higher weightage is given to various local business cycles (like inflation, deflation, boom, etc.).

Internal adjustments as remedial measures

A country that joins a currency union also loses the ability to maintain competitiveness in international trade by making "external adjustments" to its current account balance.

Greece can take "internal adjustments" as remedial measures. Such measures would include implementing an expansionary fiscal policy like lowering tax rates and other structural changes like liberalizing labor laws and reforming the bloated and corrupt public sector.

But such "structural changes" can be challenging to implement because of strong internal resistance from special interests. In such circumstances, Greece can implement another type of internal adjustment: a recession-induced deflation in which falling aggregate demand will slowly lower the domestic price level. The recession will end, but only after the price level falls by enough to induce consumers to buy more Greek products at home and abroad.