Quiz 21: Optimum Currency Areas and the Europage 669 How the European Single Currency Evolved

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Under the European monetary system (EMS), member countries of the European Union linked their currencies to prevent large fluctuations and to restore a system of fixed but, adjustable exchange rates. Periodic adjustments raised the values of strong currencies and lowered those of weaker ones. Central bank has sufficient foreign reserves to defend its currency; so, it can credit foreign reserves to a weaker currency central bank. So, when a strong- currency country's central bank is allowed, under the provisions of EMS, to give credit to the weaker-currency central bank, it helps in strengthening the weak currency. Thus, improvement in the value of the weak currency in the foreign exchange market will lead to greater EMS exchange rate stability.

According to the interest parity condition of the foreign-exchange market equilibrium, there should be a positive relationship between the interest rate differential and the exchange rate. Interest rate differential is calculated by deducting foreign country interest rate from the home country's interest rate. The exchange rate is the price of the foreign country's currency in terms of the home country currency. Since the exchange rate between the Italian and the Germany currency that is lira/DM exchange rate fluctuates within the band of ±2.25, the maximum difference between the interest rates on one-year lira and DM deposits is: img Now, for six months lira and DM deposits, the interest will compound twice a year. So, the maximum difference between the interest rates over six months is: img Similarly, for three months lira and DM deposits, the interest will compound four times a year. So, the maximum difference between the interest rates over three months is: img The answers are different in each case because, the interest rates are calculated on compounding basis.

Given that: Annual interest rate on five-year government bond in Italy is 11%. Annual interest rate on five-year government bond in Germany is 8%. First, calculate the difference in the annual interest of Italy and Germany: img Now, calculate the rate if there is 3% difference over five year's bond: img So, the expected 15.9% change in the lira/DM exchange rate over five years is much above the EMS currency band of ±2.25. Therefore, with 3% interest differentials, there is little credibility for maintaining current lira/DM exchange rate parity.