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Special Topics in Economics Econ. 491

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Special Topics in Economics Econ. 491

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  1. Special Topics in Economics Econ. 491 Chapter 6: Black Wednesday ( UK and EMU)

  2. Central exchange rates for each currency against the ECU were established, allowing a fluctuation band of 2.25% for most currencies against the central rate. • Member countries are required to intervene to make sure that their currencies stayed within the prescribed band. • Since the ECU was an artificial accounting unit, the system effectively turned into a system where the bands were maintained with respect to the most stable currency of the group, which was the ‘German Mark’. I. Background

  3. The Deutsche Mark (DM) became the unofficial reserve currency, so the ERM had a built-in lending mechanism to prevent crises from happening. • The German Central Bank (Bundesbank) is supposed to lend DM to the member country if the country needed support for its currency.

  4. Germany becomes free to set monetary policy for itself while the other countries have reduced control over monetary policy since they have to hold reserves and intervene when the exchange rate got too close to the edge of the band. • It was believed that other Central Banks were not very good at keeping inflation under control, which is why they chose Germany because they have made explicit mandates to root out inflation as its primary goal after the World Wars. • This allowed people to make long-term decisions with more certainty because the member countries fix their exchange rates to the DM, which allows the Bundesbank to dictate the monetary policy decisions. II. Germany’s Role

  5. The Reunification of East and West Germany: • The catalyst for the ERM crisis was the reunification of Germany in 1990 because the event was unprecedented in history for the merging of a large and rich economy with a smaller economy with a much lower standard of living. • In order to make the assimilation work, the West German government spend an enormous amount of money. • Almost half of all West German savings were transferred to the East and the government budget deficit rose from 5% to 13.2%.

  6. Germany’s Accelerated Effects: • By 1991, the Bundesbank was becoming very nervous about the prospects of high inflation in Germany and started pursuing contractionary monetary policy very seriously. • The combination of expansionary fiscal and contractionary monetary policy caused German interest rates to rise dramatically. • The average rate of short-term interest climbing from 7.1 % in 1989 to 8.5 % in 1990, to 9.2 % in 1991, and to 9.5 % in 1992. • The high interest rates of Germany made the situation for Britain, France, Italy, and other European countries worse because they were restrained from taking corrective monetary policy actions.

  7. Initial Speculations • As the other European economies continued to deteriorate and struggle, there was increasing pressures for the politicians in the elections for Britain, France, and Italy to offer some policy solution. • As a result, some analysts speculated that these countries might soon give up their support for the exchange rate peg against the German Mark. • A currency devaluation would help the devaluing country boost exports, and allow the country to regain the flexibility it needed to stimulate its economy through interest rate cuts.

  8. “Black Wednesday” refers to the events on September 16, 1992. • Due to major speculations and a weakening currency, the UK’s prime minister and cabinet members tried all day to prop up the sinking pound and avoid withdrawal from the ERM. • The British government raised the base interest rate from a high 10% to 12% in order to tempt speculators to buy pounds. • During that same day, it promised to re-raise the interest rates to 15%, but investors kept selling the pounds. • Even with the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets, Britain was eventually forced to withdraw from the ERM because they were unable to keep the sterling above its agreed lower limit. III. Black Wednesday & Speculative Attacks

  9. Effect of Black Wednesday • The UK Treasury spent approximately ₤27 billion of reserves in trying to defend the pound by selling Deutsche Mark and buying pounds. • The market knew that the UK could not afford to keep interest rates high for long. • The UK was not prepared to lose all of its currency reserves to simply stay in a seriously flawed ERM. • One of the most high profile currency market investors, George Sorros, made over $1 billion in profit by betting against the pound.

  10. Speculative Attacks Continue • A similar situation took place with Italy, and eventually Italy pulled the Italian Lira out of the European ERM. • The next major target for speculative attacks was the French Franc. • Elections for France were coming soon, and political pressure were mounting for a cut in the French interest rates.

  11. As with the other currencies, speculators were betting that France would devaluate the franc or withdraw from the ERM rather than maintain a high interest rate with slow growth and rising unemployment. • As the Franc came under speculative attack, the central banks of France and Germany intervened aggressively to hold their exchange rate link by buying Francs and selling Marks. • Bank of France raised interest rates to defend the Franc, and both France’s and Germany’s central bank continued to intervene directly to support the Franc.

  12. UK satisfies most convergence criteria • Two economic sources of UK hesitation to join: a) There is evidence that UK may not form an optimal currency union with the rest of the EU b) The pound may be overvalued relative to the Euro Thus, if the UK enters the Eurozone at too high an exchange rate it might be saddled with low competitiveness for years to come, putting downward pressure on economic growth in the UK IV. Is the UK ready to enter the Eurozone?

  13. Figure : Euro–pound exchange rate (1999–2011)