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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?

Solution Preview

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?

The maximum difference between the Italian and German interest rate would be 2.25% annualized.
maximum difference between the Italian and German interest rate
one-year lira and DM deposits =2.25% annualized
six-month lira and DM deposits= 2.25% annualized (or 1.125 % for 6 months)
Three-month lira and DM deposits= 2.25% annualized (or 0.5625 % for 3 months)

These results follow from interest rate parity.
The returns on both lira and DM deposits should be the same.
Thus if DM deposits offers an interest rate of 4 % per annum and the lira depreciates by 2.25 % per annum then the lira deposits should offer 4%+2.25%=6.25% per annum.
Keeping the depreciation rate the same on a 6 month period the DM deposits would yield a return of 4 %/2= 2 %. The lira deposits should therefore yield a return of 2 % + (2.25%/2=1.125%) = 3.125 % on a six month deposit.

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?

It would not be credible since the difference in interest rate (both on Government bonds of same duration , so ...

Solution Summary

The solution discusses 4 questions on Exchange rate band, interest rate parity, pegging of currency, and the role of central banks in managing currency.

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