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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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