After the reunification of Germany, payments to rebuild the former East Germany led to a major expansion of aggregate demand in Germany. The German central bank responded by raising German real interest rates. These actions took place in the context of the European Monetary System, in which most countries had fixed exchange rates and where the German central bank was dominant in monetary policy.
a. Explain why European countries having fixed exchange rates and following the lead of the German central bank would find their interest rates rising along with German interest rates. Explain why other European countries would thereby be plunged into deep recessions.
b. Explain why countries would prefer the European Monetary Union to the earlier system.
c. Trace through why this German monetary tightening would be expected to lead to a depreciation of the dollar. Explain why the depreciation would stimulate economic activity in the United States.