In preparation for membership in the European Monetary Union (EMU), countries had to participate for 2 years in the European Monetary System (EMS). The EMS served to ensure that potential member-countries are able to maintain stability of their exchange rates relative to one another before they join the EMU and they effectively give up their currency. The German currency, the Deutsche Mark (DM), was considered the benchmark currency due to Bundesbanks (Germanys central bank) reputation in maintaining low ination and a strong, stable currency.
(a) In 1996 Italy entered (for a second try) the EMS. What kind of constraints did this impose on macroeconomic stabilization policies in Italy? Were there similar constraints for Germany?
(b) Italy at that time had a fixed exchange rate against the DM, but a floating rate against the dollar. Which framework is appropriate for analyzing Italys economy floating or fixed? Why?