Presentation on theme: "What caused the ERM crisis? By Tim & Dan. Background The European Monetary System (EMS) was established in 1979 with 8 countries joining. Part of this."— Presentation transcript:
Background The European Monetary System (EMS) was established in 1979 with 8 countries joining. Part of this was the Exchange Rate Mechanism (ERM): countries fixed their exchange rates against each other allowing only fluctuations within bands. Britain joined the ERM in 1990.
Background (II) Monetary policy would have to prevent the exchange rate from fluctuating by more than 6%. The pound entered the mechanism at 2.95 DM to the pound. If the exchange rate ever neared the bottom of its permitted range, 2.778 DM, the Bank of England would intervene by selling reseves/buying pounds to make pound appreciate.
Background (III) Within ERM Germany was dominant; others countries followed German interest rate policy as the Bundesbank had a good reputation as inflation fighter From the early 90s, the Bundesbank raised interest rates to counteract inflationary effects from German reunification strengthened DM against e.g. USD
The Crisis ERM implied that the pound appreciated against USD as well harmful for already struggling UK economy (unemployment rate 1992: 9.8%) Speculators (George Soros) foresaw that situation was unsustainable shorted pound more downward pressure on pound Sep 16, 1992: British government raised interest rate from 10% to 15% didnt help 7pm: Britain leaves ERM; interest rates back to 12% George Soros shorted $10bn and made $1.1bn
Links to theory The ERM crisis can be thought of as a Second Generation crisis Governments seek to minimise following loss functions: If stay fixed L=[b(e*-ē)+E(ė)] 2 If float L=[E(ė)] 2 +C, where b(e*-ē) is the cost of not being able to follow an expansionary monetary policy C is loss of credibility to the monetary authority/ government and E(ė) is costs of expected future depreciation.
Links to theory (II) Consider the case when market expects a devaluation then the government faces a payoff of either [(1+b)(e*-ē)] 2 OR C+(e*-ē) 2 During months leading up to ERM crisis the penalty of not following an expansionary policy increased Once the LHS>RHS loss minimised by devaluing
Empirics SPI-approach –spi=a*(Δ 12 (1/neer))-b*Δ 12 res+c*tbill where Δ 12 x=log(x t )-log(x t-12 ) –when spi>mean+sd speculative attack
Speculative Pressure Index 2 stdev 1 stdev ERM-crisis