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If countries commit to defending their currencies against appreciation only, it's impossible to engage in a race to the bottom. Suppose that Greece wants to game the system and its central bank buys lots of German securities with new fiat Drachma. If the Bundesbank had an obligation to defend the Mark against excessive appreciation, they could just buy off all those drachma with new fiat DM. The net result would be an increase in DM holdings by the Greek Central Bank and Drackma holdings by the Bundesbank. But there need not be any upwards pressure on DM asset prices or indeed on the exchange rate or on German inflation. And the Bundesbank is much bigger than the Bank of Greece.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Apr 10th, 2012 at 04:31:48 AM EST
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If the Greek CB wanted to put downward pressure on the D-Mark/Drachma exchange rate, they would sell into the open market, not bilaterally to the BuBa. And if the BuBa defended against it, the spread between the Greek attack bid and the BuBa defense bid would go to some arbitrageur, who would accumulate some combination of D-Mark and Drachma, which he would then either spend on goods (giving him a free lunch at the expense of the Greek and German citizens), or (more likely) exchange for other currencies in the open market, putting downward pressure on the D-Mark/Drachma couple.

Eventually one of the principal participants would bow out, the other would set whatever discount it wanted relative to the rate at which the former stopped defending its discount. You would have discovered the exchange rate which neither central bank could feasibly attack (and since the central banks, collectively, have greater pricing power than any speculator, by inference also from speculative attack).

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Apr 10th, 2012 at 04:59:38 AM EST
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