Answer to Question #252128 in Macroeconomics for Biba

Question

7. After the reunifi cation of Germany in 1990, payments to rebuild the East led to a major expansion of aggregate demand in Germany. The German central bank responded by slowing money growth and raising German real interest rates. Trace through why this German monetary tightening would be expected to lead to a depreciation of the dollar. Explain why such a depreciation would stimulate economic activity in the United States. Also explain why European countries that had pegged their currencies to the German mark would fi nd themselves plunged into recessions as German interest rates rose and pulled other European rates up with them.

Answer 1

A number of reasons contributed to the delayed pace of economic recovery in eastern Germany. Economic reconstruction efforts were hampered by the haste with which changes were made, particularly with regard to currency conversion and the dismantling of the great industrial conglomerates, as well as the fact that East Germany had no effective government for three months following the economic union in July 1990. Progress was dismal even after political union. As a result of the drop in demand for dollars, dollars became cheaper in the foreign exchange market, increasing demand for U.S. goods. And selected European countries that had linked their currencies to the German mark had to buy their own currency in foreign exchange markets or boost interest rates to keep their currencies from sinking. This move damages their export markets and forces their economy to come to a halt. So, here's the full definition of the caution: investors were more likely to put their money in Germany and less likely to save in the United States when interest rates in Germany rose.

As a result of the drop in demand for dollars, dollars become cheaper in the foreign exchange markets, increasing demand for U.S. goods and services. To avoid their currencies from depreciation against the German mark, European countries had to buy their own currency on the foreign exchange markets and boost interest rates.