Economic Commentary: Croatia Prepares For Euro Switch Amid Soaring Inflation
Submitted for IB HL Economics Coursework (economic analysis of a contemporary article using a key syllabus concept; the global economy), 800 words
Background
Article: Croatia Prepares For Euro Switch Amid Soaring Inflation, 29th October 2022 (archive)
Date the commentary was written: 21st February 2023
Unit of the syllabus to which the article relates: The Global Economy
Key concept being used: Intervention.
Commentary
Croatia has made the economic choice to join the eurozone. This decision highlights how economic decision-makers must choose between competing alternatives: here, whether to replace the kuna with the euro.
One basis for moving towards this greater integration is as a hedge against increasing inflation that is affecting Croatia. The proximate cause of this inflation is the supply-side shocks resulting from the Russo-Ukrainian war, leading to an increase in food and energy costs. This has increased firms’ cost of production and led to a decrease in aggregate supply (AS), to AS1 on Figure 1; assuming ceteris paribus, aggregate demand (AD) remains constant, thus causing cost-push inflation, shown in the increase from PL to PL1.
Croatia believe that their inflation will be curbed by joining this monetary union, because it will make it easier for them to borrow from their European partners. The reason for this is that being part of the eurozone signals to lenders that Croatia is committed to meeting the stability requirements to become a member, reducing the perceived risk associated with lending to them, leading to lower borrowing costs. Perhaps Croatia also believes that the European Central Bank (ECB) will lend to them at lower interest rates, as a eurozone country. With more favourable borrowing conditions, individuals and businesses will borrow more and invest in new projects, which will increase aggregate supply, counteracting the shift seen in Figure 1, and therefore the inflation.
However, there are some problems here. For example, one factor arguably contributing to eurozone countries having experienced lower inflation is their monetary policy. The ECB has been ‘embarking on a policy of monetary tightening’, decreasing the money supply of the Euro – from MS€ to MS€1 in Figure 2, so interest rates increase from r1 to r2.
The rationale for this is that if interest rates go up, then borrowing will become more expensive, so businesses and individuals will reduce their borrowing – and therefore their consumption and investment. This decreases aggregate demand from AD to AD1 on Figure 3. Assuming ceteris paribus, AS remains at AS1, so inflationary pressure decreases, with price levels moving from PL1 to PL2.
Although the policy reduces inflation, it fails to deal with its main cause: the shift in AS, not AD. Hence, the ECB’s monetary policy also conflicts with other macroeconomic objectives – it leads to a further fall in economic growth, with RNO decreasing to y3, and probable unemployment in the longer-term, as firms are reluctant to hire new workers in anticipation of weak demand persisting in future.
The trade-off here is that Croatia will become subject to the ECB’s monetary policies even if they do not align with Croatia’s specific economic conditions. The existence of this policy casts doubt on whether Croatia can actually gain access to favourable borrowing conditions from inside the eurozone: it is unlikely the ECB will be keen to lend money to Croatia whilst seeking to restrict the money supply.
Furthermore, this decision is permanent: even if the decision were beneficial in the short-run, Croatia loses its ability to decide which macroeconomic goals they wish to prioritise. Although fiscal and supply-side tools would remain available, it would become much harder to seek some outcome if their monetary policy, controlled by the ECB, sought contradictory ends. For instance, if Croatia wished to prioritise economic growth over reducing inflation, then that tight monetary policy might ‘cancel out’ the effects of Croatian expansionary fiscal policy. Hence, it may be disadvantageous to Croatia in the long-run, as they can no longer make choices autonomously and in light of their particular situation and priorities.
Another reason for Croatia joining the eurozone is in the interest of greater price transparency. As they are already in the European Union, many prices are already denominated in euros. Furthermore, a fifth of Croatia’s GDP is made up of exporting tourism, largely to other European countries. Therefore, replacing the kuna with the euro completely will enable tourists to make more informed decisions: this increases consumer surplus and perhaps incentivises more tourism into Croatia, fuelling growth.
Conversely, it might be argued that price transparency will simply expose how poor Croatia is compared to its neighbours, potentially reducing tourism and leading to lower growth. Since tourism is a large proportion of Croatia’s GDP, this might be too risky – especially since the euro is already mostly used, so the gains from changing would be smaller.
Economics is a study of choices: and Croatia’s choice to join the eurozone perhaps satisfies certain wants in the present, such as protection against mounting inflation. However, the consequence of choices must be considered with respect to both the present and the future, and the economic costs of this decision – lost autonomy of monetary policy, potential limitations on growth, and risk of reducing tourism competitiveness – seem steep in comparison to the benefits.
Result
Averaged across this and two other commentaries:
Raw Mark: 41/45 (Grade 7)
Moderated Mark: 33/45 (Grade 6)