Exercise 2 Answer what the following items request.

a. Currency crises are normally followed by a sharp fall in economic activity, which results in recession. Based on the first-generation currency crises model and the Mundell
Fleming model, seen in Section 7.1, explain why this happens.

258 PRINCIPLES OF INTERNATIONAL FINANCE AND OPEN ECONOMY MACROECONOMICS

b. Consider two distinct countries that decided to adopt a fixed exchange rate regime. The first country operates with a fiscal deficit, while the second operates with a surplus. How can the difference in the fiscal situation of each of these two countries affect the credibility of monetary regime adopted?

c. Exposure to speculative attacks is a disadvantage of a fixed exchange rate regime. Explain why speculative attacks are costly for policymakers.

d. Using the Mundell
Fleming model seen in Section 7.1, explain why the lack of credibility in a fixed exchange rate regime increases the cost of maintaining a determined exchange rate parity.