The Impact of Capital Liberalization on the Financial Markets in the European Monetary System: An Empirical Investigation

Journal of International Financial Markets, Institutions & Money
Volume 4, 1994

Gordon M. Bodnar
Wharton School, University of Pennsylvania and NBER

Abstract

This paper examines the influence of capital controls and their liberalization on the markets for the French franc, German Mark, and Italian Lira over the period 1982-1990. France and Italy show evidence of capital enforcement in the first half the 1980's; however by June 1988, these money markets joined Germany in showing no signs of arbitrage opportunities. Liberalization also resulted in a decrease in the mean and volatility of franc and lira interest rates to deutschemark levels. This convergence is traced to a stabilization of exchange rate expectations within the EMS. Tests suggest that liberalization has played a direct role in stabilizing expectations by decreasing the market's probability of exchange rate realignment within the EMS.