In 1992, several European countries had their individual currencies pegged to the ECU (a precursor to the euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German deutschmark (DM). This question considers how dierent countries responded to the European Exchange Rate Mechanism (ERM) Crisis. For the following questions, you need only consider short-run eects. Also, treat Germany as the foreign country.

(a) Following the economic consequences of German reunication in 1990, the Bundesbank (Germanys central bank) raised its interest rate. On September 14, 1992, Great Britain decided to oat the British pound ( ) against the DM. Using the FX and money market diagrams and treating Britain as the home country, illustrate the eects of Germany increasing its interest rate. (10 points)

(b) After Britain abandoned the ERM (i.e. allowed its currency to oat against the DM), investors grew concerned that France would no longer be able to maintain its currency peg. The Banque de France (Frances central bank) wanted to keep its currency (French franc, FF) pegged to the DM. Using the FX and money market diagrams and treating France as the home country, illustrate the eects of Germany increasing its interest rate, assuming the currency peg is maintained. (10 points)

(c) Denmark had a similar experience to that of Britain and France. Suppose Denmarks prime minister approaches you about how to respond. He doesnt want to give up monetary policy autonomy, but wants to maintain the exchange rate peg. Is this possible?