"Consider a small open economy with fixed exchange rates. Suppose the central bank announces that it will devalue the currency by 50% one year from today. What are the consequences of this announcement?"
IIRC, the whole point of the Euro was that questions like that wouldn't make any sense, and so would never need to be asked again, and so we wouldn't have to face the ugly answers. It hasn't worked out that way. That same question is back on the exam paper, only in a more ambiguous form.
Nobody knows exactly which assets are denominated in domestic currency units and which assets are denominated in foreign currency units. Maybe bank deposits will be devalued, but bank notes won't. Some debts will be devalued, but other debts won't. Nobody knows exactly how much foreign exchange reserves the central bank has, or can borrow from foreign central banks. The students are raising their hands, asking the professor to clarify the exam question. But the professor doesn't know either, because he didn't write this question.
But there's no choice on the exam paper, so the students just have to do the best they can with what they've got.
The students know roughly what must happen.
People will want to sell domestic currency assets to buy foreign currency assets. The BP curve will shift up, raising domestic nominal interest rates. The central bank will lose foreign exchange reserves, and will seek to borrow reserves from other central banks (Target2). If the central bank runs out of reserves and cannot borrow enough from other central banks, it will be forced to devalue immediately, rather than a year from today. The increased interest rates would cause a recession, which would cause a movement along the Short Run Phillips Curve and reduce the inflation rate. But at the same time the Short Run Phillips Curve might shift up, if firms increase prices in anticipation of the inflationary consequences of the future devaluation. The real exchange rate might even rise, temporarily, thus worsening the recession.
This was precisely what the Euro was supposed to avoid, by making it impossible to imagine a future devaluation. Currency boards were supposed to avoid that too, by making it impossible for the central bank to run out of reserves. Argentina showed that didn't work, because you still need a lender of last resort for the commercial banks; plus high enough real interest rates and a big enough recession will force the central bank to devalue today even if it still has enough reserves.
The same question is back on the exam paper. Currency boards don't work to keep it off. Common currencies don't work to keep it off.
[This post is an attempt to get my economics brain back up to speed after a fortnight in England doing other things. The Euro crisis is the only thing that really matters now. Peter Boone and Simon Johnson are very pessimistic. So am I.]