There are different types of exchange rates that are classified according to the way the government controls a country. The exchange rates that governments can use are fixed, pegged, managed float and freely floating. The currency that is used in Italy is the Euro since January 1999 (Dash, 1999). The exchange rate system that is used in Italy is the freely floating exchange rate system. In this exchange rate system, the market force determines the exchange rates of the currency in a government.
The fluctuations of exchange rate exposure are managed by the multinational corporations. The advantages that are faced by Italy due to the use of the freely floating exchange rate system are that inflation and unemployment are not exported. The economy of the country is managed by the central bank. The investors of the country will invest funds in the countries that use fixed exchange rate systems and has the highest rates of interest. The funds that leave the country are restricted by other countries, for example tax withholding (Dash, 1999).
In the fixed monetary agreements, all the government currencies are pegged to the dollar. This was during the Era of Bretton Woods in the years of 1944 to 1971. In this era, all the currencies could no drift from the initial value that was established to more than one percent. In 1971, there was the Smithsonian Agreement in which the dollars due to the trade deficit balance were overvalued. In this agreement, the other currencies were valued 10% higher than the dollar in which there was a widened range of 2.25%.
According to the multinationals corporation perspective, the fixed exchange rates are used due to easy plan in the multinational corporations since there are no changes in the exchange rates. The governments in the multinational corporations can however revalue or devalue their exchange rates and currencies. Revaluation means that they government can boost the imports and help in the inflation prevention of the country while government can boost the exports of the country in the devaluation (Dash, 1999).
In order for a government to make decisions on the monetary policy and investment, there is need of analysing the relationship between interest rates and expectations of inflation in a country. The EU countries such as Italy issues the inflation linked bonds in order to deduce the inflation expectations of the country (Berardi, 2005, p. 1). In order to understand the link between the inflation expectations and the interest rates, the government of Italy explores the cross sectional restrictions of the yields of bonds, inflation and the growth output.
There is a structural model that can be used in order to analyze the link between inflation expectations and interest rates. The model is used for obtaining the growth output expectation estimates which are then used along with the expectations of inflations to create assumption on the monetary policy (Berardi, 2005, p. 2). There are considerable interrelations of the interest rates and inflation expectations according to the practical analysis which therefore demonstrates the positive association of the inflation expectations and output growth (Berardi, 2005, p.2).
According to Jegadeesh & Pennacchi (1996), there is a considerable mean reversion of the rates of the expected inflation. In Italy, there is a decrease in the volatility of the interest rates with the maturity of the country (Berardi, 2005, p. 9). The rates of the expected inflation are lower in Italy than the real interest rates. In Italy, the central bank controls the inflation strictly which therefore determine the positive relationship between rates of the expected inflation rates and the real interest rates (Goto & Torous, 2003).
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