A 1991 front-page article in The Wall Street Journal entitled "Foreign Rate Increases May Worsen Slump" explained how the German central bank (the Bundes bank) raised the domestic real risk-free interest rate in order to reduce inflation below a 3% level.
a. Explain the pressures that a rising German real risk-free interest rate put on the other EU countries' currencies. Specifically, assume exchange rates within the EU were absolutely fixed. Explain the economic effects a rise in Germany's real risk-free interest rate put on the German mark (i.e., deutsche Mark) per French franc exchange rate (i.e., DM/FF) and what the French central bank (i.e., the Bank of France) had to do to keep the exchange rate fixed. Then, explain the resulting changes in France's real and nominal GDP, monetary base, M2 money supply, real risk-free interest rate, nominal interest rate, balance of payments accounts (i.e., CT, NI, and RA), real investment spending, unemployment rate, GDP Price Index, and real exchange rate.
b. Explain what the German central bank (i.e., the Bundes bank) had to do to keep the exchange rate fixed. How would the economic results have differed if the Bundes bank intervened rather than the Bank of France?