Question: Before World War II started, the German currency, which was then the Reichsmark, was set at 2.5 to the dollar. After the war ended, the occupying forces set its successor, the Dmark, at 4.2 to the dollar. The undervalued currency was probably based on the likelihood that productivity in Germany would be much lower because of wartime destruction.

(A) By 1970, German production had made great strides, and labor costs were still fairly low, so the Dmark was clearly undervalued at 4.0 to the dollar (there had been one slight appreciation in 1961). Explain the underlying monetary and fiscal policies that would be consistent with an undervalued currency and a modest current account surplus.

(B) Over the next decade, the Dmark appreciated very rapidly relative to the dollar, reaching a value of DM1.8 by 1979. Explain the shifts in the NX and NFI curves that must have occurred to boost the value of the currency that much. What effect do you think that had on the German economy?