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British Pound Crisis 1992 Essay

2495 words - 10 pages

Table of Content
Question 1 .........................................................................................................................1
Question 2. ........................................................................................................................2
Question 3. ........................................................................................................................4
Question 4 .........................................................................................................................6
References .........................................................................................................................8

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In 1990, unemployment started to rise in Great Britain and a recession began. In
April 1990, 1.6 million people were unemployed in Great Britain. In order to strengthen
its economy, Great Britain could have lowered interest rates. This, however, would have
weakened the currency because Germany kept its interest rates high to avoid inflation
after its reunification in late 1990. Therefore, lower interest rates in Great Britain would
have caused higher capital exports resulting in a depreciation of the British Pound. The
exchange rate would have dropped and less Deutsche Mark would have been necessary
to buy 1 British Pound. Hence Great Britain would not have been able to fulfil the
requirements of the ERM anymore. However, rising unemployment and a negative GDP
growth (1991: around minus 1.5 %, data source: International Monetary Fund, 2010)
provided a good reason for Great Britain to give up the exchange rate peg and leave the
ERM.
As Great Britain kept interest rates high, the costs of keeping the exchange rate
peg rose. High interest rates lead to lower investment, lower consumption and therefore
rising unemployment. Due to high interest rates, cash outflows for the government and
indebted enterprises increased and consequently overall costs of keeping the exchange
1

rate peg rose. At the end of 1991, 2.9 million people in Great Britain were unemployed.
The unemployment rate had almost doubled compared to April 1990.
In conclusion, the crisis scenario of the British Pound in 1992 follows the
“second generation model”. On the one hand, Great Britain had a good reason to keep
the peg because of political reasons, and on the other hand, it had good reason to give
up the peg because of economic problems and rising costs for keeping the peg because
of increasing interest rates and lower government cash flow.

Question 2: Why did this represent a “classical one-way-bet scenario”?
Explain.
The British Pound was regarded as being overvalued by George Soros, investors,
speculators and the Deutsche Bundesbank. The initial exchange rate of 2.95 Deutsche
Mark for 1 British Pound was regarded as being set too high as the British Pound
depreciated in real terms over time compared to its entry level as described in the
following figure (M. Zurlinden: The vulnerability of pegged exchange rates, 1993)

Fig.1: Nominal/Real DM/Pound Exchange Rates during UK’s ERM period
(source: M. Zurlinden: The vulnerability of pegged exchange rates, 1993)

2

The recession in the UK and the high unemployment rate emphasized the fact that
Britain could not have kept up the high exchange rate versus the Deutsche Mark
forever. Britain was forced to act and asked the Deutsche Bundesbank to lower its
interest rates to help both Britain and other European countries such as Italy and Spain
having the same problem. The Deutsche Bundesbank, however, refused to lower its
interest rates because of inflationary tendencies resulting from the...

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