The establishment of the Euro as a unit of account in 1999 meant that from then on the currencies of the participating countries traded at a fixed rate, until the Euro completely replaced these currencies in year 2002.

a) What would the inflation rates of these countries have to be in these transition years for RPPP to hold?

b) If the inflation of Italy was twice as high as that of Germany in one year between 1999 and 2002, what can we say about the Italian lira against the German mark? (Which currency became overvalued/undervalued?)

c) What does the concept of PPP tell us about what needs to happen for such a monetary agreement to work for a long period of time?

(a ) The inflation rate of all the countries participating in the Euro agreement must be equal (b ) The Italian lira was overvalued in relation to German mark and other currencies. (c) The European central bank must regulate the monetary policies of the participating countries for such a monetary agreement to work for a long period of time

Explanation:

(a) The fixed exchange rate is when a government stipulates an official price for its currency in terms of another currency. Since the currencies of the participating countries traded at a fixed rate, untill the Euro completely replaced these currencies in year 2002. Then the inflation rate of the participating countries must be the same for the PPP to hold because the PPP explains that for a long run equilibrium to hold among the countries participating in the Euro then their inflation rates have to be equal in all the countries.

(b) Since the inflation rate was twice as high as that of Germany in one year between 1999 and 2002. The Italian lira became overvalued in relation to the German mark and other currencies of the participating countries in the Euro.

(c) The concept of PPP states that for countries long run equilibrium to exist among the countries in the Euro zone, their inflation rate must be equal since their individual currencies has been replaced by Euro . Then the European central bank which was established as a monetary policy regulator of all the countries in the Euro zone must regulate the monetary policies of these countries for the PPP to hold.

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