At the 2014 G20 conference in Canberra, U.S. Secretary of the Treasury, Jack Lew, warned that the euro zone economies face a decade of economic stagnation unless their economic policies change and that the “world economy could not afford a European lost decade”. Joining this criticism was Prime Minister David Cameron of the United Kingdom. The German government came under increasing pressure at these meetings over the persistent current account surplus that Germany has been running in recent years. These surpluses, it is argued, have helped to contribute to the poor economic performance of, especially, some of the other countries in the euro zone. These critics urged the euro zone in general and Germany in particular to take measures to shrink its surplus. Criticisms of Germany raised at the 2014 conference continue to this day at both the IMF and from various government leaders.

Use the Mundell-Fleming model to try to understand the basis for this criticism and show a possible policy that Germany might pursue that could have a beneficial impact on another member country of the euro zone. (Hints: 1. assume that there are two countries, Germany and Spain; 2. both of these countries are in the euro zone and neither can run independent monetary policies (feel free to assume that the ECB acts to keep interest rates constant--or perhaps, if you prefer, to allow them to rise slightly above--the pre-policy change level; 3. there is perfect capital mobility; 4. prices remain constant in both countries; and 5. assume Spanish exports to Germany will rise if German GDP rises.)

a) Given the hints above, how do the equation(s) of the model (presented in Chapter 7) change for Spain? Describe any new parameter(s) required for the model. Major hint: look at the previous paragraph for a suggestion.

b) Assuming that Germany wants to be helpful to its neighbors, what does the model suggest that Germany should do to address the criticism described above? In a set of graphs, show the impact of your recommendation on the German and Spanish economies. In the new equilibrium, what will be the impacts on German and Spanish output levels, interest rates, and CABs? Explain in a sentence or two.

b) Assuming that Germany takes the actions you prescribed in Part I, assume now that the entire eurozone economy (think of it as one large country) behaves in the manner described above. Assume further that there is one other large economy in the world called ROW (i.e. rest of the world) and that the euro floats against the currencies of the rest of the world. Finally, assume that ROW exports rise with economic growth in the eurozone (again describe any parameter you may need to add to the model and where that parameter might appear). Draw graphs to show the impact of your policy recommendation on both the eurozone and on the economy of ROW. For simplicity you may assume perfect capital mobility worldwide.