Financial Markets and Institutions (2-downloads)

1

2

D

2

E

3

3

F I G U R E   1 6 . 3

Foreign Exchange Market for British Pounds in 1992

The realization by speculators that the United Kingdom would soon devalue the pound

decreased the relative expected return on British pound assets, resulting in a leftward shift of

the demand curve from 

D

2

to

D

3

. The result was the need for a much greater purchase of

pounds by the British central bank to raise the interest rate so that the demand curve would

shift back to 

D

1

and keep the exchange rate 

E

par

at 2.778 German marks per pound.

---

Chapter 16 The International Financial System

387

German interest rates would raise the relative expected return on British assets

and shift the demand curve back to D

1

so the exchange rate would be at E

par

.

The catch was that the Bundesbank, whose primary goal was fighting inflation,

was unwilling to pursue an expansionary monetary policy, and the British, who were

facing their worst recession in the postwar period, were unwilling to pursue a con-

tractionary monetary policy to prop up the pound. This impasse became clear when

in response to great pressure from other members of the EMS, the Bundesbank

was willing to lower its lending rates by only a token amount on September 16 after

a speculative attack was mounted on the currencies of the Scandinavian countries.

So at some point in the near future, the value of the pound would have to decline

to point 2. Speculators now knew that the depreciation of the pound was immi-

nent. As a result, the relative expected return of the pound fell sharply, shifting

the demand curve left to D

3

in Figure 16.3.

As a result of the large leftward shift of the demand curve, there was now a

huge excess supply of pound assets at the par exchange rate E

par

, which caused a

massive sell-off of pounds (and purchases of marks) by speculators. The need for the

British central bank to intervene to raise the value of the pound now became much

greater and required a huge rise in British interest rates. After a major intervention

effort on the part of the Bank of England, which included a rise in its lending rate

from 10% to 15%, which still wasn’t enough, the British were finally forced to give up

on September 16: They pulled out of the ERM indefinitely and allowed the pound

to depreciate by 10% against the mark.

Speculative attacks on other currencies forced devaluation of the Spanish peseta

by 5% and the Italian lira by 15%. To defend its currency, the Swedish central bank

was forced to raise its daily lending rate to the astronomical level of 500%! By the

time the crisis was over, the British, French, Italian, Spanish, and Swedish central

banks had intervened to the tune of $100 billion; the Bundesbank alone had laid

out $50 billion for foreign exchange intervention. Because foreign exchange crises

lead to large changes in central banks’ holdings of international reserves and thus sig-

nificantly affect the official reserve asset items in the balance of payments, these

crises are also referred to as balance-of-payments crises.

The attempt to prop up the European Monetary System was not cheap for these

central banks. It is estimated that they lost $4 to $6 billion as a result of exchange

rate intervention during the crisis.

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