Exchange Rate - Parity

1. Before September 1992, the lira/DM exchange rate could fluctuate by up to 2.25 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 U.S. dollar, and benefits from a shift in world demand towards American exports. What happens to the exchange rate of the Brazilian currency against non-U.S. 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?