Question 1

[25 points] In November 1998 the government of Mozzarellia (it is the name of a country) announces that its country will join the European Monetary Union (EMU) by the 1st of January 2001.
Let us assume that the new European Central Bank will keep money supply constant, and will achieve the target of zero inflation.
Currently, the government of Mozzarellia is running a primary budget deficit (G-T) of 3% of GDP, which it finances by printing money. Assuming the government of Mozzarellia has no debt, its budget constraint is:
$G-T=\frac{M_{t+1}-M_t}{P_t}$
a) what is the amount $\frac{M_{t+1}-M_t}{P_t}$ called?
The government of Mozzarellia also announces that it will reduce G by year 2001 so that G=T, and the public believes it.
b) assume inflation before the announcement was 10%. Will inflation after the announcement be above or below 10%?
c) why?
d) will the nominal interest rate decrease or increase after the announcement (assuming the real interest rate is fixed)?
By January 1999, however, the long awaited reforms of the pension system in Mozzarellia are stalled, and none believes that the promised reduction in G will be carried on anymore. Suppose also that taxes cannot be raised for political reasons.
e) will Mozzarellia still make it into the monetary union? and if it does make it, is there a chance that it is going to back out at some point? why?
f) EMU has imposed the following rules on future member countries: primary budget deficits should not exceed a given amount, and countries should try to lower the amount of outstanding government debt before entering the union. Interpret such rules in the light of the example of Mozzarellia.