Economic Commentary: Eurozone interest rates set to rise for first time in 11 years
Submitted for IB HL Economics Coursework (economic analysis of a contemporary article using a key syllabus concept; macroeconomics), 800 words
Background
Article: Eurozone interest rates set to rise for first time in 11 years, 9th June 2022 (archive)
Date the commentary was written: 23rd February 2023
Unit of the syllabus to which the article relates: Macroeconomics
Key concept being used: change.
Commentary
The European Central Bank (ECB) is proposing to hike interest rates to curb inflationary pressures for the first time in 11 years. This highlights the importance of change in the economic world, and of adapting to how things are, rather than maintaining a status quo.
The inflation could be demand-pull, caused by changes in components of aggregate demand (AD); or cost-push, caused by the increase in energy prices – caused by supply chain issues resulting from the 2022 Russo-Ukrainian War – being passed onto the consumer. It is concurrent with rising food and energy costs; this, and the recency of the supply-side issues, suggests that this is cost-push inflation. But though growth forecasts for 2022 have been cut, output has not fallen in the eurozone – it has risen by 2.8%, shown in the shift from y to y1 on Figure 1. This suggests that although AS has decreased to AS1, because of those factors, AD has increased more than AS decreased, to AD1. This led to 8.1% inflation – from PL to PL1.
Therefore, although the apparent causes of the inflation are supply-side, there are also demand-pull pressures. As such, the ECB must focus not on the level of these variables, but on the empirical change shown by the data, at institutional, structural and economic levels. In any case, it is difficult for the ECB to counter the supply-side issues, since they arise from factors outside their control.
Thus, their policy decision to raise interest rates makes loans more expensive, disincentivising individuals and firms from borrowing, to spend on private consumption or capital investment respectively. Since these are both AD components, AD decreases, to AD2 on Figure 2.
Assuming ceteris paribus, aggregate supply remains at AS1. It is impossible to ascertain how much AD will decrease following the proposed change, but it is improbable that it will return to precisely its original level, as the ECB have imperfect information with respect to precisely how consumers and businesses will respond. Nevertheless, Figure 2 shows that this policy might alleviate inflation without countering it wholly, and simultaneously cause a fall in Real Output to y2. On this diagram, if AD decreases enough for prices to return to their original levels, this will fall even further, potentially leading to a recession.
Avoiding this would entail minimising how much inflation can be curbed, suggesting that the ECB has chosen to prioritise price stability over output. Perhaps this is because price stability engenders greater consumer and business confidence in the long-run. Although in the short-run, this approach might cause low consumer and business confidence – decreasing consumption and investment, as stated – prices remaining predictable will cause this to rise over time, eventually leading to increases in consumption and investment, leading to sustained economic growth.
However, this could lead to inequity. Though prices are predictable, high costs of borrowing disproportionately affects the poorest consumers, who are already struggling with “desperately high living costs”. Though those who are better off might become more confident and spend more in the long-run, high interest rates could lead to some struggling with tuition loans or mortgages. Furthermore, with high interest rates, the advantage of larger firms over smaller businesses will become even more pronounced. They will be able to exploit financial economies of scale – so larger firms have the ability to access business loans more easily, because there is less perceived risk associated with them. Smaller firms by contrast will find it much harder to invest, especially with private consumption so diminished that it will be difficult for them to gain momentum and sell.
A monetary solution such as this does come with certain advantages. In particular, changing interest rates in this way is an incrementable and easily reversible approach. If it were to turn out that this change came with too many negative side-effects, such as those described, the situation remains adjustable so as to optimise the balance between price stability and output.
Moreover, although inflation will be “elevated for some time” – there is a time lag between policy implementation and discernible impact – it is still significantly quicker than a supply-side solution, which are designed to increase the productive capacity of the economy in the long-term and therefore take longer to implement and show results.
It is also cheaper to the involved governments. Though borrowing for government spending becomes more expensive, it is substantially cheaper than supply-side policies such as stockpiling oil and gas in peacetime so that the shortage is less pronounced in the present conditions, or bailing out consumers from the burden of their rising energy bills.
Therefore, the policy reflects the need to adapt to the continual state of flux characteristic of the economic world, and the way that institutions must react to profound change in the geopolitical landscape, like the Russo-Ukrainian War; it is an imperfect, but sensible solution.
Result
Averaged across this and two other commentaries:
Raw Mark: 41/45 (Grade 7)
Moderated Mark: 33/45 (Grade 6)