In 1992, several European countries had their individual currencies pegged to the ECU (a pre-cursor to the euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German deutschmark (DM). This question considers how two different countries responded to the European Exchange Rate Mechanism (ERM) Crisis. For the following situations, you need only consider short-run effects. Also, treat Germany as the foreign country. (a) Following the economic consequences of German reunification in 1990, the Bundesbank (Germany’s central bank) raises its interest rate. On September 14, 1992, Great Britain decided to float the British pound (£) against the DM. Using the

In 1992, several European countries had their individual currencies pegged to the ECU (a pre-cursor to the euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German deutschmark (DM). This question considers how two different countries responded to the European Exchange Rate Mechanism (ERM) Crisis. For the following situations, you need only consider short-run effects. Also, treat Germany as the foreign country.

(a) Following the economic consequences of German reunification in 1990, the Bundesbank (Germany’s central bank) raises its interest rate. On September 14, 1992, Great Britain decided to float the British pound (£) against the DM. Using the foreign exchange market, the money market, and treating Britain as the home country, graphically illustrate the effects of Germany increasing its interest rate on Great Britain.

(b) After Britain abandoned the ERM (e.g., allowed its currency to float against the DM), investors grew concerned that France would no longer be able to maintain its currency peg. Applying monetary tools, the Banque de France (France’s central bank) wanted to keep its currency (French franc, FF) pegged to the DM. Using the foreign exchange market, the money market, and treating France as the home country, graphically illustrate the effects of Germany increasing its interest rate on France, assuming the currency peg is maintained.

(c) Denmark had a similar experience to that of Britain and France. Suppoise Denmark's prime minister appraoches you about how to respond. He doesnt want to give up monetary policy autonomy, but wants to maintain the exchange rate peg. Is that possible? explain why or why not.