2. ERM Mechanism

The lira and the Belgium franc are participating in the ERM with the +/- 2.25% band i.e. the

currencies are allowed to fluctuate by this percentage around the central parity (the official peg).

Assume that thecentral paritybetween the Belgium franc and the lira is 31.5 Lira per BF and that, within a year, the market exchange ratebetween the two currencies increases from 31.8 lira per BF to 32.3 lira per BF.

a. Which of the two currencies has appreciated?Lira. OR Belgium Franc

b. Calculate whether this new exchange rate (32.3 Lira/BF) is still within the acceptable band for these two ERM currencies.

c. If the currencies are out of the acceptable band, explain the mechanism of compulsory

intervention necessary to bring the two currencies back into the band. Answer in terms the action of each central bank, the Bank of Italy and the Bank of Belgium.

d. Assuming that the movements in the exchange rates were due to different rate of inflation, which country had the lower rate of inflation?

e. What is the impact of intervention on the real exchange rate of the country that has the lower rate of inflation? (a real depreciation or a real appreciation)

What is the resulting effect on its international competitiveness?