1. You are the economic advisor to Sir Bufton Tufton, the prime minister of Perfidia. The Bank of Perfidia is pegging the exchange rate of the local currency, the Perfidian albion. The albion is...

1. You are the economic advisor to Sir Bufton Tufton, the prime minister of Perfidia. The Bank of Perfidia is pegging the exchange rate of the local currency, the Perfidian albion. The albion is pegged to the wotan, which is the currency of the neighboring country of Wagneria. Until this week both countries have been at full employment. This morning, new data showed that Perfidia was in a mild recession, 1% below desired output. Tufton believes a downturn of 1% or less is economically and politically acceptable but a larger downturn is not. He must face the press in 15 minutes and is considering making one of three statements:

a. “We will abandon the peg to the wotan immediately.”

b. “Our policies will not change unless economic conditions deteriorate further.”

c. “We shall never surrender our peg to the wotan.”

What would you say to Tufton concerning the merits of each statement?

2. What steps have been proposed to prevent exchange rate crises? Discuss their pros and cons.