THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 563

CHAPTER 20

The International Financial System

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required to buy francs and sell marks, thereby giving up international reserves.
Similarly, the German central bank was also required to intervene to sell marks
and buy francs and consequently increase its international reserves. The EMS thus
required that intervention be symmetric when a currency fell outside the limits,
with the central bank with the weak currency giving up international reserves and
the one with the strong currency gaining them. Central bank intervention was also
very common even when the exchange rate was within the limits, but in this case,
if one central bank intervened, no others were required to intervene as well.
A serious shortcoming of fixed exchange rate systems such as the Bretton
Woods system or the European Monetary System is that they can lead to foreign
exchange crises involving a speculative attack on a currency massive sales of
a weak currency or purchases of a strong currency that cause a sharp change in
the exchange rate. In the following application, we use our model of exchange
rate determination to understand how the September 1992 exchange rate crisis that
rocked the European Monetary System came about.

A PP LI CATI O N

The Foreign Exchange Crisis of September 1992
In the aftermath of German reunification in October 1990, the German central
bank, the Bundesbank, faced rising inflationary pressures, with inflation having
accelerated from below 3% in 1990 to near 5% by 1992. To get monetary growth
under control and to dampen inflation, the Bundesbank raised German interest
rates to near double-digit levels. Figure 20-3 shows the consequences of these
actions by the Bundesbank in the foreign exchange market for British pounds.

Note that in the diagram, the pound is the domestic currency and the German
mark (deutsche mark, DM, Germany s currency before the advent of the euro in
1999) is the foreign currency.
The increase in German interest rates i F lowered the relative expected return of
British pound assets and shifted the demand curve to D2 in Figure 20-3. The intersection of the supply and demand curves at point 2 was now below the lower
exchange rate limit at that time (2.778 marks per pound, denoted Epar ). To increase
the value of the pound relative to the mark and to restore the mark/pound
exchange rate to within the exchange rate mechanism limits, one of two things had
to happen. The Bank of England would have to pursue a contractionary monetary
policy, thereby raising British interest rates sufficiently to shift the demand curve
back to D1 so that the equilibrium would remain at point 1, where the exchange
rate would remain at Epar. Alternatively, the Bundesbank would have to pursue an
expansionary monetary policy, thereby lowering German interest rates. Lower
German interest rates would raise the relative expected return on British assets and
shift the demand curve back to D1 so the exchange rate would be at Epar.
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 contractionary 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 14 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