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 the year 2002

Question

(a) How would the inflation rates of these countries have to had been in these transition years for PPP to hold? (b) If the inflation of Italy was twice as high as that of Germany a year between 1999 and 2002, what can we say then about the Italian lira against the German mark? (c) What does the concept of PPP thus tells us about what needs to happen for such this monetary agreement to work for a long period of time?

Answer 1

(a) The inflation rates of the participating countries must be equal for PPP to hold. (b) The Italian lira became overvalued with respect to the German mark and the other currencies.
(c) Given that the exchange rates are fixed, the concept of PPP tells us that for a long-run equilibrium to hold among these countries, the inflation rates must be the same. Once the euro replaced the old individual currencies, the newly formed European central bank now handles the monetary policy of all the participating countries, so that PPP will hold, just like it does for the different states of the U. S.