3. Denmark pegs their currency, the krone, to the euro.

a. (10 points) Draw two diagrams, side by side with the money market diagram

for Denmark on the left and the expected return in krone / exchange rate

diagram on the right hand side. Label the initial equilibrium point A.

Denmark suffers from an adverse productivity shock and goes in a recession.

Show how your two diagrams are affected by the recession in Denmark.

Assume that the peg is credible.

b. b) (10 points) Suppose Denmark prefers to fight the recession via counter-

cyclical monetary policy by increasing the money supply in hopes of

lowering interest rates in Denmark. Explain what would happen...i.e., would

they be successful or not? Be sure to mention capital flows and use the

term(s) 'capital flight' and/or 'hot money,' whichever applies. Make sure to use

a balance sheet - T - account for Denmark's central bank and show/explain

how the money supply changes endogenously.