THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 564

532

PA R T V I

International Finance and Monetary Policy

Exchange Rate, Et
(DM/ )

Epar * 2.778

S

1

E2

2

E3

3

D3

D2 D1

Quantity of British
Pound Assets

FIGURE 20-3

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 D2 to D3. 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 D1 and keep the exchange rate Epar at 2.778 German marks per pound.

the pound was imminent. As a result, the relative expected return of the pound
fell sharply, shifting the demand curve left to D3 in Figure 20-3.
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 Epar, 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 US$100 billion; the Bundesbank alone had laid
out US$50 billion for foreign exchange intervention. Because foreign exchange
crises lead to large changes in central banks holdings of international reserves and
thus significantly 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 US$4 billion to US$6 billion as a result of
exchange rate intervention during the crisis. What the central banks lost, the speculators gained. A speculative fund run by George Soros ran up US$1 billion of profits during the crisis, and Citibank traders reportedly made US$200 million. When an

exchange rate crisis comes, life can certainly be sweet for exchange rate speculators.