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 E2 E3 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