Suppose that Albernia’s central bank has fixed the value of its currency, the bern, to the U.S. dollar (at a rate of US$1.50 to 1 bern) and is committed to that exchange rate. Initially, the foreign exchange market for the bern is also in equilibrium, as shown in the accompanying diagram. However, both Albernians and Americans begin to believe that there are big risks in holding Albernian assets; as a result, they become unwilling to hold Albernian assets unless they receive a higher rate of return on them than they do on U.S. assets. How would this affect the diagram? If the Albernian central bank tries to keep the exchange rate fixed using monetary policy, how will this affect the Albernian economy?

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Exchange rate (U.S. dollars per bern) 1.50 0 L D S Quantity of berns