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.

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.

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 he wants to maintain the exchange rate peg. Is this possible? Explain why or why not.

d. Compare and contrast the three approaches above. Which would you favor as a policymaker? Explain.