In 1992, several European countries had their individual currencies pegged tothe ECU (a precursor to the euro) in anticipation of forming a common currencyarea. In practice, this meant that countries were pegged to the German deutschmark (DM). This question considers how different countries respondedto the European Exchange Rate Mechanism (ERM) Crisis.For the following questions, you need only consider short-run effects. Also,treat Germany as the foreign country.
1. An increase in the interest rateFollowing the economic consequences of German reunification in 1990, the Bundesbank(Germany's central bank) raised its interest rate. On September 14,1992, Great Britain decided to float the British pound (£) against the DM.Using the FX and money market and treating Britain as the home country,illustrate the effects of Germany increasing its interest rate.
2. Maintaining a pegAfter Britain abandoned the ERM (allowing its currency to float against theDM), investors grew concerned that France would no longer be able to maintainits currency peg.The Banque de France (France's central bank) wanted to keep its currency(French franc, FF) pegged to the DM. Using the FX and money market andtreating France as the home country, illustrate the effects of Germany increasingits interest rate, assuming the currency peg is maintained.
3. Maintaining a peg, againDenmark had a similar experience to that of Britain and France. SupposeDenmark's prime minister approaches you about how to respond. He doesn'twant to give up monetary policy autonomy, but wants to maintain the exchangerate peg. Is this possible? Explain why or why not.