Suppose the country of Petria is seeking membership in a currency union, the CU, that uses a currency unit called the curo. The exchange rate is currently 2 Petrian dollars per curo. Petria’s inflation rate is 7% versus 4% in the three CU countries with the lowest inflation rates. The world real interest rate is 2.5%. Assume that the CU uses the Maastricht Treaty convergence criteria.

a. Using the UIP condition and the definition of the real interest rate, calculate the expected depreciation in the Petrian dollar (relative to the curo).

b. Does the country of Petria meet the nominal convergence criteria? Which ones does it satisfy? Which ones are not satisfied? Explain.

c. Suppose that Petria reduces its inflation rate to 3.25% over the next few years and its nominal interest rate declines to a value consistent with this inflation rate (according to the Fisher effect). Will it satisfy all the nominal convergence criteria in this case? If not, which criteria are not satisfied?

d. Suppose instead that Petria experiences an economic recession, causing its deficit/GDP ratio to rise to 4%. In your opinion, what is Petria’s appropriate response? Explain.

e. How might your answer to (d) differ if Petria were already a member of the CU? How does this relate the effectiveness of the SGP in Europe?