The European Union: Structure and Function

The European Union

• The EU is a supranational political, economic and monetary union of 27 sovereign states.
• Established in 1993, the EU's single market facilitates the free movement of goods and services.
• The EU functions as a Customs Union, applying a common external tariff on goods entering the single market.
• The EU operates through a system of supranational and intergovernmental decision-making institutions, adhering to principles of conferral and subsidiarity.
• The EU operates through a series of decision-making bodies.
• The EU has a common currency, the Euro.

Economic Union

• Established in 1993, it promotes the free movement of goods and services within the EU.
• It includes a Customs Union where a common external tariff is applied to goods entering the single market.
• Goods within the single market experience no customs duties, discriminatory taxes, or import quotas.

Political Union

• The EU functions through a combination of supranational and intergovernmental decision-making bodies.
• Decision-making is governed by the principles of conferral and subsidiarity.
• Conferral refers to the EU acting only within the limits of its delegated powers.
• Subsidiarity implies the EU intervenes only when an objective cannot be adequately achieved by individual member states.

The Euro

• The Euro was introduced as a common currency for many EU member states.
• It offers advantages like the elimination of exchange rate uncertainty and transaction costs.
• It promotes economic and financial integration within the Eurozone.
• It provides a framework for greater budgetary discipline among members.
• The Euro presents potential disadvantages including the loss of monetary and exchange rate policies, restricted fiscal options, and potential asymmetric shocks.

The Theory of Optimal Currency Areas

• This theory explores the factors determining the optimal geographical scope of a currency area.
• Introduced by Robert Mundell, it highlights a first condition, which is integration in the trade of goods and services.
• It emphasizes the importance of shared economic cycles, flexible labor markets, and fiscal integration.

Fiscal Integration

• Fiscal Integration is a crucial aspect of managing a currency area effectively.
• Fiscal integration can be achieved with better supervision, temporary transfers, and provisions of public services.
• In essence, fiscal integration involves creating mechanisms for sharing resources and risks among member states.
• The establishment of a rainy day fund, a common unemployment insurance system, or a Euro area budget are different approaches to enacting fiscal integration.

Risk Sharing.

• The concept of risk sharing centers on the principle of assisting member states experiencing negative asymmetric shocks.
• This can be achieved through fiscal transfers from member states, a central government, or through the creation of a dedicated fund.

Centralized Budgets and Automatic Transfers

• A central government, or a central fiscal authority, creates a centralized budget, enabling the redistribution of resources.
• Although automatic, the central authority has the power to adjust transfers based on fiscal priorities and economic conditions.
• The central authority can also provide public services through a centralized budget, which can also function as a risk-sharing mechanism.

The Transfer Union

• The Transfer Union promotes the equalization of public service quality and living standards across different territories.
• This is accomplished by fiscal transfers from richer territories to those experiencing economic challenges.
• The Transfer Union acts through a central government or a central fiscal authority.

The Role of Central Governments

• Central governments play an important role in facilitating risk sharing within a currency area.
• This can be achieved through fiscal adjustments to government spending, taxation, or through the creation of dedicated funds.
• Central governments can use budgetary tools to redistribute resources and mitigate economic shocks.

National Income

• National Income (NI) = Gross National Product (GNP) - Depreciation of capital (K) - Indirect Taxes + Subsidies

Origin of Income

• Labor: salary, wages, payments in kind
• Capital: profits, dividends, interest
• Land: rental income, capital gains

Disposable Income

• Disposable Income = NI - Direct Taxes + Public Sector Transfers to Families
• Disposable Income (Yd) = Consumption (C) + Savings (S)
• Private saving is the portion of disposable income not consumed

Aggregate Expenditure

• Gross Domestic Product (GDP) = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (NX)

GDP - Expenditure Approach

• GDP can be calculated by summing up all spending on final goods and services in an economy

Aggregate Supply and Demand

• GDP depends on the evolution of demand components in the short term
• GDP depends on the evolution of supply conditions in the long term, including: technological innovations, productivity of labor, and capital.

GDP Trend

• GDP trend can be observed over time
• GDP growth is influenced by both aggregate demand and long-term supply factors
• The short-term trend is driven by fluctuations in aggregate demand (C + I + G + NX)
• The long-term trend is driven by the ability to produce goods and services (productivity)

Value Added

• Value Added = Value of sales - Cost of embedded intermediate goods
• It measures the contribution of capital and labor to production
• GDP is equivalent to the sum of value added, earned incomes, and total expenditures

Balance of Payments (BOP)

• Measures all economic transactions between a country and the rest of the world
• BOP can be in surplus or deficit
• Surplus: Foreign exchange reserves increase
• Deficit: Foreign exchange reserves decrease
• Ideally, a country should have a stable BOP balance

BOP Balance Types

• Current account deficit can be offset by a financial account surplus - typical of developing economies
• Current account surplus allows for a financial account deficit - typical of developed economies and export-driven developing economies

BOP Equilibrium

• BOP equilibrium occurs when the current account balance plus the financial account balance (including changes in foreign exchange reserves) equals zero

Current Account Deficit

• Exports less than imports
• Financial Account Surplus: inflow of capital (loans received from the rest of the world)
• Leads to the accumulation of external debt

Current Account Surplus

• Exports greater than imports
• Financial Account Deficit: outflow of capital (loans to the rest of the world)
• Leads to the country becoming an external creditor

Global Current Account Imbalances

• Different countries have varying current account balances
• These imbalances can reflect economic structures, trade patterns, and investment flows

Important Identities

• Identity 1 (without external sector): Savings (S) = Investment (I)
• Identity 2 (without external sector): Savings (S) = Investment (I) + Public Deficit
• Identity 3 (with external sector): Savings (S) = Investment (I) + Public Deficit + Current Account Balance OR Savings (S) + Financial Account Balance = Investment (I) + Public Deficit

Unemployment

• Labor Force: people who are of working age and are looking for a job
• Employed: people who have a job
• Unemployed: people who do not have a job and are looking for one
• Unemployment Rate = (Unemployed / Labor Force) x 100

Labor Force Participation Rate

• Labor Force Participation Rate = (Labor Force / Population of working age) x 100
• Only those looking for work are counted as unemployed
• People not working and not looking for work are not part of the labor force
• Discouraged workers are those without jobs who give up looking for work

The Public Sector

• The government plays a vital role in the economy

Functions of Government:

• Preserve market competition
• Regulate monopolies, mergers, and acquisitions
• Correct market failures
• Provide public goods, correct externalities
• Redistribute wealth to ensure a more equitable society
• Fight recessions
• Steer the economy in the long run through investments in strategic sectors and basic research

Public Budget

• A record of all revenues and expenditures of the public sector
• Revenues: taxes (direct and indirect)
• Direct taxes: income tax
• Indirect taxes: VAT, corporate taxes
• Expenditures: Public spending (including public investment) and transfers to the private sector

Public Budget Balance

• Public Budget Balance: Revenues - Expenditures
• Surplus: Balance > 0
• Deficit: Balance < 0
• Primary Budget Deficit: Public Budget Deficit excluding interest payments on public debt