Denmark pegs their currency, krone, to euro.
a. Sketch two diagrams, side by side with money market diagram for Denmark on the left and expected return in krone / exchange rate diagram on the right hand side. Label the initial equilibrium point A. Denmark suffers from the unfavourable productivity shock and goes in the recession. Illustrate how your two diagrams are affected by recession in Denmark. Suppose that the peg is credible.
b. Assume Denmark prefers to fight recession through counter-cyclical monetary policy by increasing the money supply in hopes of lowering interest rates in the Denmark. Describe what would happen...i.e., would they be successful or not? Be sure to state capital flows and employ the term(s) 'capital flight' and/or 'hot money,' whichever applies.