Solution Exercise 3 Mock
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In 1992, several European countries had their individual currencies pegged to the
ECU (a precursor to the euro) in anticipation of forming a common currency area. In
practice, this meant that countries were pegged to the German Deutsch Mark (DM).
This question considers how different countries responded to 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.
a. Following 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.
Answer: See the following diagram.
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. 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
and treating France as the home country, illustrate the effects of Germany
increasing its interest rate, assuming that the currency peg is maintained.
Answer: See the following diagram. Point B illustrates the outcome under a
floating exchange rate regime. Point C shows the outcome for France.
c. Denmark had a similar experience to that of Britain and France. Suppose
Denmark’s prime minister approaches you about how to respond. He doesn’t want
to give up monetary policy autonomy, but wants to maintain the exchange rate
peg. Is this possible? Explain why or why not.
Answer: Yes, it is possible. If Denmark imposes capital controls, restricting the
flow of financial capital between Denmark and Europe/Germany, then the
government would be able to maintain the exchange rate peg with monetary
policy autonomy. This is because the FX market would not be in equilibrium, as
investors would be unable to arbitrage away differences in the domestic (Danish)
and foreign (German) returns.
d. Compare and contrast the three approaches above. Which would you favor as a
policy maker? Explain.
Answer: It depends on which of the three objectives (exchange rate stability,
international capital mobility, and monetary policy autonomy) the country values
most.
10. In the late 1990s, several East Asian economies had their currencies pegged to the
U.S. dollar. Suppose there is an economic boom in the United States that leads to an
increase in U.S. interest rates. At the same time, investors begin to worry that the East
Asian economies will be unable to maintain their exchange rate pegs. How could
policy makers in these countries respond? What are the pros and cons of these
options? Discuss how the trilemma applies to this situation.
Answer: In this case, there are two factors that make foreign deposits (U.S.) more
attractive: the expected depreciation in the domestic (East Asian) currency, and the
increase in foreign (U.S.) interest rates. Both of these cause the foreign return to
increase. There are three options the policy maker must choose among: sacrifice the
exchange rate peg, sacrifice international capital mobility, or sacrifice monetary
policy autonomy.
■ In the first case, the government could abandon the exchange rate peg, allowing
its currency to float against the U.S. dollar. The benefit of this approach is that it