In the era before the euro, the exchange rate between the Spanish peseta and the German Deutsche Mark was characterized by significant volatility. For a number of years, the peseta underwent a rapid and substantial depreciation against the more stable Deutsche Mark.

Pre-Euro Exchange Rate Volatility: Spanish Peseta vs. Deutsche Mark

The exchange rate between the Spanish peseta and the German Deutsche Mark (DM) from 1960 to 2024 can be characterized by three distinct periods. Initially, during the 1960s, the rate was stable and low. Starting in the early 1970s, the peseta began a steep and prolonged depreciation against the DM, a trend that lasted until the mid-1990s when the rate peaked at about 160 pesetas per DM. After this peak, the exchange rate stabilized and remained almost constant with very little movement.

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Figure 7.20 presents data for pre-euro Spain and for Denmark to empirically test the predictions of Uncovered Interest Parity (UIP) by comparing their interest rates to their anchor economies (Germany and the Eurozone, respectively). The data for Denmark provides strong empirical evidence for the loss of monetary autonomy, showing its policy rate is 'pinned down' and tracks the ECB's policy rate very closely. The figure also provides the data for analyzing Spain's pre-euro interest and exchange rate movements in the context of the UIP model.

Figure 7.20: UIP Predictions vs. Interest Rate Patterns in Spain and Denmark

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

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Graph: Spanish Peseta to Deutsche Mark Exchange Rate (1960-2024)

In the period before Spain and Germany adopted the euro in 1999, their monetary policies were less formalized than modern inflation-targeting regimes, lacking a single, clearly defined policy interest rate. To analyze their economies, economists use the interest rates on government bonds as a proxy. This is a valid approach because each government borrowed in its own currency (the peseta and the Deutsche Mark, respectively), which made these bonds effectively free of default risk and thus a good substitute for the policy rate.

Using Government Bond Rates as a Proxy for Policy Interest Rates in Pre-Euro Spain and Germany

An analysis of Spain's interest rates and exchange rate movements against Germany before the adoption of the euro shows that the observed patterns are generally consistent with the predictions of the Uncovered Interest Parity (UIP) model. This conclusion holds true when the key assumptions underlying the UIP model are taken into consideration.

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