The home country of Albion is pegging its pound to the euro. Interest rates in Albion

(i) and euro (i*) are currently both at i=i*=4%, the peg is credible, and output is 100

in each country. But speculators may decide to attack the Albion pound.

The ECB, which controls the euro, now decides to change its interest rate i* for some

reason. It will pick a rate of 4, 5, 6, 7, 8, 9, or 10%. The change is unanticipated.

If the Albion home interest rate i rises, all else equal, the effect is to lower

employment and output in the short run. Suppose Albion output falls respectively

with each 1% point increase in the home interest rate to 99, 98, 97, 96, 95, and so

on. (I.e., 1 unit of output is lost for every 1% point increase above 4%.)

Assume that politically, as everyone knows, the Albion government won't sacrifice

its economy to the peg once output falls to a level of 96 (or lower): at that point

everyone believes the Albion government will allow the exchange rate to follow a

2% depreciation for one year, and then remain fixed forever at the new rate.

a. If speculators think the peg is credible, there is no currency premium and

i=i*. But if they think the peg is going to break as above, and is not credible, what

size of currency premium (in % per year) will they impose on the pound? [2]

___________ %

b. Fill in this table, one row at a time; hint: some entries are provided: [5]

ECB interest rate

choice

4% 5% 6% 7% 8% 9% 10%

In the case where

speculators think the

peg is credible

Albion

interest rate 4% 5% 6% 7%

Albion output 100 99

In the case where

speculators think the

peg is not credible

and the currency

premium is present

Albion

interest rate 6% 7%

Albion output

In the last 3 parts of the question refer to the columns in the table in your answers

c. At what ECB rates are speculators certain not to attack? [1] _______________________

d. At what ECB rates are they certain to attack? [1] __________________________________

e. At what ECB rates are there two equilibria? [1] _________________________________