Exercise 5 Assume an integration mechanism similar to the European Monetary System (EMS),11 however, with only two countries: Germany and France. Assume that Germany has an independent monetary policy while that of France is dedicated to maintaining the exchange rate francs/marks fixed at level S0. Answer the following questions, which deal with the impact of the German reunification on this reduced version of the EMS.

a. If the uncovered interest rate parity is valid and if the French exchange policy is credible, what would be the relation between the French and German interest rates?

b. The reunification of Germany resulted in a substantial increase in public spending and private investments. What is the impact of this shock on the IS curve for the German economy? What is the effect on the IS curve for the French economy?

c. Assume there is no change in money supply in Germany. Use your answers to the previous items to determine the postunification interest rate and real output in France.

Assuming that the French central bank defends the exchange rate of S0, is it possible to determine if the German unification will increase or decrease the French output?

Illustrate your answer by means of graphs for the IS and LM curves for both countries.

d. In 1992, the German central bank adopted a more contractionist monetary policy due to inflationary pressure. What would be the impact of this policy on the real output and interest rate in France if the French central bank intends to defend the exchange rate of S0? Illustrate your answer with a graph.