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Category Archives: E32

Proposing an Alternative to the European Central Bank’s Fiscal Convergence Criteria

By Junaid Arefeen

The recent onset of the sovereign debt crisis in the Eurozone has brought the viabil-ity of the Eurozone as a currency area into question. The unsustainable debt and deficit balances accumulated by several Eurozone nations since the adoption of the common currency in 1999, and the consequent incidence of high levels of sovereign default risk in the euro-area, indicate that the fiscal convergence criteria employed by the European Central Bank to monitor the fiscal discipline and sustainability of its members have been largely ineectual. This paper draws upon the theory of optimum currency areas, and proposes a set of business cycle convergence criteria that can be employed as an alternate means to minimize the risk of fiscal imbalances and sovereign default. Economic theory suggests that a currency union with convergent business cycles will be insulated from asymmetric shocks, removing the need for countries to rely wholly on their fiscal policies when dealing with negative shocks (as would be the case in a currency union with non-synchronous countries suering from negative asymmetric shocks). Therefore, as the risk of fiscal imbalances is minimized, a currency union with synchronous business cycles is expected to have low incidences of sovereign default risk. This paper tests this economic intuition empirically, and employs a multivariable panel regression model to determine the relationship between business cycle convergence and sovereign default risk (proxied using sovereign yield spreads). The regressions reveal that the degree of business cycle convergence is one of the main determinants of yield dierentials, and the relationship between the two is negative (as expected). The consistency of the results to numerous robustness checks provide a strong case for substituting the current fiscal convergence criteria with measures that assess the degree of business cycle convergence.

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Advisor: Andrea Lanteri, Cosmin Ilut | JEL Codes: E32, E43, F34, F44, F45 | Tagged: Cycle Convergence, Optimum Currency Area, Sovereign Default Risk

Inflation Volatility and Economic Growth: A Disaggregated Analysis

By Nicholas Becker

Inflation volatility has been theorized to negatively affect real economic growth, but empirical analyses have returned somewhat mixed results. Constructing my own dataset of household group inflation rates by disaggregating and linking Consumer Expenditure Survey data with Consumer Price Index data, I analyze inflation volatility and economic growth from the ground-up. Calculating inflation volatility using a moving-window methodology, I find: 1) significant heterogeneity of inflation volatility across household groups; 2) a negative correlation between inflation volatility and economic growth from 2000-2012 for all household groups, with a stronger negative correlation at lower income levels; 3) a positive correlation between volatility and growth during expansions and a negative correlation between volatility and growth during recessions. Results suggest reducing inflation volatility and refining policymaking to account for the heterogeneity of inflation volatility could improve growth over the longrun. Further analysis is warranted.

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Advisor: Nir Jaimovich | JEL Codes: E31, E32, O40 | Tagged: Inflation, Economic Growth

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