Exchange Rate – Parity 1 Before September 1992, the lira/DM exchange rate could fluctuate by up to 225 percent up or down If central banks ensured that the lira/DM exchange rate band was set in this...

Exchange Rate – Parity

1 Before September 1992, the lira/DM exchange rate could

fluctuate by up to 225 percent up or down If central banks ensured that the

lira/DM exchange rate band was set in this way and could not be changes, then

would have been the maximum possible difference between Italian and German

interest rates in one-year lira and DM deposits? What would be the maximum

possible difference between the interest rates on six-month lira and DM

deposits? On three-month deposits? Why these results?

2 In the last scenario, if the interest rate on five-year

government bonds was 11 percent per annum in Italy and 8 percent per annum in

Germany, would the lira/exchange parity be credible? Have you assumed that

interest rates and expected exchange rates are linked by interest parity? Why?

3 Suppose Brazil pegs against the US dollar, and benefits

from a shift in world demand towards American exports What happens to the

exchange rate of the Brazilian currency against non-US currencies? How is

Brazil affected? How does the size of this effect depend on the volume of trade

between Brazil and the United States?

4 Imagine that the European Monetary System (EMS) became a

monetary union with a single currency but that it created no European Central

Bank to manage that currency Instead, the task was left to various central

banks which were allowed to issue as much of the European currency as they

wished and to conduct open market operations What problems can you see

arising?