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

a. 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. 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. describe 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

Microeconomics, Economics

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