European Debt Crisis

The European Debt Crisis- A Way Out?

The European sovereign debt crisis has been characterized by rising deficits and debt levels in Europe, particularly countries like Greece and Spain which has made it harder for European governments to borrow money and as a result these countries are finding it difficult to finance their activities.(Sen, A., 2012:28). One of the policy solutions implemented is fiscal austerity which involves the European Union reducing government expenditure or increasing taxes, however there is debate whether this policy will have a positive effect on Europe’s current situation. This essay will use the IS-LM model to critically analyze the effectiveness of an austerity fiscal policy in Europe; it will further discuss whether monetary policy has a role to play in Europe’s financial crisis and will finally suggest another policy which could help stabilize Europe’s economy.

Let us begin by looking at the orthodox model of fiscal austerity. If the European Union decided to implement fiscal austerity by each European nation either decreasing government spending or increasing taxes to reduce their respective budget deficits we would have a scenario depicted by the graph below.

Figure 1

A decrease in government spending through budget cuts or an increase in taxation would lead to European consumers having less disposable income and as a result consumption would decrease which would result in less goods being demanded. Less goods being demanded would lead to less goods being produced in the European economy which would drop the level of output. A drop in the demand for goods would mean that consumers would be spending less money and this would lead to the European Central Bank lowering interest rates. Graphically this can be seen as the leftward shift from “IS1” to “IS2” and a decrease in the equilibrium output from “Y1” to “Y2” and a decrease in the equilibrium interest rate from “i1” to “i2’ for Europe. There will be a movement along the LM...