Question

8. On Friday, September 13, 1992, the lira was worth DM 0.0013065. Over the weekend, the lira devalued against the DM to DM 0.0012613.

a. By how much has the lira devalued against the DM?

b. By how much has the DM appreciated against the lira?

c. Suppose Italy borrowed DM 4 billion, which it sold to prop up the lira. What were the Bank of Italy’s lira losses on this currency intervention?

d. Suppose Germany spent DM 24 billion in an attempt to defend the lira. What were the Bundesbank’s DM losses on this currency intervention?

show ALL calculations.

Answer 1

a. Let us assume the september 13, 1992 price of lira against DM as (P1) = 0.0013065 and over the weekend the price of lira changed against the DM to (P0) = 0.0012613, to calculate the devaluation we use the formula:

P0-P1/P0*100 = 0.0012613 - 0.0013065/0.0012613* 100 = -3.46%

b. To calculate the appreciation in DM we need to find how much DM equlas 1 lira on Friday september 13, 1992:

1 Lira = 0.0013065 DM therefore 1 DM = 1/0.0013065 = 765.403 Lira and over the weekend 1 Lira = 0.0012613 DM, therefore 1 DM = 1/0.0012613 = 792.832 Lira. Now let us calulate the increase in the value of DM against Lira

792.832 - 765.403/765.403 = 27.429/765.403 * 100 = 3.58%.

c. Before devaluation, DM billion was worth Lira(4 billion/0.0013065). After the devaluation, 4billion worth of DM borrowing would cost for the Italian government Lira (4 billion/0.0012613) to repay. Therefore the loss for the italian government would be Lira 4 billion* [(1/0.0012613) - (1/0.0013065)] = Lira 109,716,164344, or DM 138,384,998.

d. German centeal bank would have bought Lira24 billion/0.0013065. After the devaluation, the Lira would become DM (24 billion/0.0013065) x 0.0012613, or DM 23,169,690,012, due to which there is a foreign exchange loss for the German central bank for the amount of DM 830,309,988.