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BBC Six o'clock news 16th September 1992 Sterling crisis

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Ultimately Sterling was ejected from the Exchange Rate Mechanism and devalued.

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gavyn davies article on chinese renminbi

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How do currency values rise and fall? Why would a country want to manipulate the value of its own currency? "(Macro) Episode 33: Exchange Rates" by Dr. Mary J. McGlasson is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License.

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In Britain, Black Wednesday (Sept.16, 1992) is known as the day that speculators broke the pound. They didn't actually break it, but they forced the British government to pull it from the European Exchange Rate Mechanism (ERM). Joining the ERM was part of Britain's effort to help the unification of the European economies. However, in the imperialistic style of old, she had tried to stack the deck.

Although it stood apart from European currencies, the British pound had shadowed the German mark in the period leading up to the 1990s. Unfortunately, the desire to "keep up with the Joneses" left Britain with low interest rates and high inflation. Britain entered the ERM with the express desire to keep its currency above 2.7 marks to the pound. This was fundamentally unsound because Britain's inflation rate was many times that of Germany's.

Compounding the underlying problems inherent in the pound's inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. The drive for European unification also hit bumps during the passage of the Maastricht Treaty, which was meant to bring about the euro. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces.

Spotting the writing on the wall, Britain upped its interest rates to the teens to attract people to the pound, but speculators, George Soros among them, began heavy shorting of the currency.

The British government gave in and withdrew from the ERM as it became clear that it was losing billions trying to buoy its currency artificially. Although it was a bitter pill to swallow, the pound came back stronger because the excess interest and high inflation were forced out of the British economy following the beating. Soros pocketed $1 billion on the deal and cemented his reputation as the premier currency speculator in the world.

For more on Soros' feat against the British pound, read The Greatest Currency Trades Ever Made and The Greatest Investors: George Soros.

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How did George Soros break the Bank of England?

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In Britain, Black Wednesday (Sept.16, 1992) is known as the day that speculators broke the pound. They didn't actually break it, but they forced the British government to pull it from the European Exchange Rate Mechanism (ERM). Joining the ERM was part of Britain's effort to help the unification of the European economies.

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The Chinese government have been criticised for the 'manipulation' of their currency. They would prefer not to use the word 'manipulation' perhaps they have an unofficial exchange rate target to keep Chinese currency undervalued to promote growth and exports. At the moment China only pegs its currency against the dollar and not a wider basket of currencies.When the UK was in the Exchange Rate Mechanism, we were trying to target a semi-fixed exchange rate. Though in 1992, we had to work hard to keep the Pound above its market value, whereas the Chinese are working to keep it lower.
Q. What does it Mean that the Chinese Currency is Undervalued?
An undervalued currency suggests that agents (i.e. Government) are keeping the currency below it's 'fair' market equilibrium price by currency controls and intervention buying.

Many analysts argue that in a free market, the Chinese Yuan would appreciate because of the strong demand for Chinese goods and the large Chinese Current Account Surplus. However, the Chinese government is trying to prevent the currency rising. Essentially, the Chinese Central Bank is buying Dollar assets which increase the value of the US dollar relative to the Chinese currency.

This policy of buying foreign assets has led China to accumulate $2.4 trillion of foreign currency reserves. ( China's Foreign Currency Reserves)
Why is China Pursuing this Policy?
China is pursuing a policy of reducing the value of its currency to try and boost growth, especially in its key exporting industries. Chinese growth is very high by western standards. However, China needs a high rate of growth to absorb labour that is made unemployed from the agricultural sector. Because China doesn't have much in the way of social welfare payments, it is concerned that without job creation in the manufacturing sector they could face high unemployment and social unrest. Therefore, keeping a weak currency helps to boost demand for Chinese exports and therefore Chinese jobs.
Why is US Unhappy at Situation?
By keeping the dollar strong, US exports become less competitive. Also by keeping the dollar strong to the Chinese Yuan, it makes Chinese imports relatively more attractive, increasing foreign demand at the expense of domestic producers. The US argues this loss of Demand and jobs is something it can't afford at its particular stage in the economic cycle.

Large current account surplus is an indication that China's currency is undervalued. Though this current account surplus has been decreasing in recent years.
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Chinese Currency Manipulation - Economics Help

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The Chinese government have been criticised for the 'manipulation' of their currency. They would prefer not to use the word 'manipulation' perhaps they have an unofficial exchange rate target to keep Chinese currency undervalued to promote growth and exports.

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An overvalued exchange rate implies that a countries currency is too high for the state of the economy. An overvalued exchange rate means that the countries exports will be relatively expensive and imports cheaper. An overvalued exchange rate tends to depress domestic demand and encourage spending on imports.

An overvalued exchange rate can also be measured by looking at purchasing power parity PPP. An overvalued exchange rate will mean goods are relatively more expensive in that country. (a more sophisticated form of PPP also takes into account difference in real GDP per capita - Beefed up Big Mac Index at Economist)

An overvalued exchange rate is particularly a problem during a period of sluggish growth. If the economy is booming, an overvalued exchange rate can help reduce inflationary pressure, but in a recession, an overvalued exchange rate can cause further deflationary pressures.

Example of Overvalued Exchange Rates

In 2011, both Switzerland and Japan witnessed an appreciation in their currency. This appreciation occurred because investors were worried about finding secure investments in a period of economic uncertainty. However, because the global economy remained depressed (slow growth, high unemployment), this appreciation was unwelcome. It makes it more difficult to export goods and can lead to lower growth. For an economy like Japan which relies on a strong export sector, this decline in competitiveness could be damaging to their economy.

This is why both Switzerland and Japan sought to intervene to try and reduce the value of their currency.

Overvalued Exchange Rates in the Euro

OECD: 2010

In 2010, countries like Portugal and Greece ran a current account deficit of close to 10%. This is because they didn't have their own exchange rate to enable a depreciation. In the Euro, they faced an overvalued exchange rate.

Greece and Portugal became uncompetitive because they had relatively higher inflation rates than other Eurozone economies. For example, rising labour costs not met by improved productivity.

This combination of higher prices and lower productivity makes their goods less attractive, leading to more imports and fewer exports; hence the very large current account deficits

If they had their own exchange rate, we would see a devaluation in the currency making exports more competitive and imports cheaper. This would help reduce the size of the current account deficit.

For example, the UK has had a persistent current account deficit, but with an independent exchange rate, the exchange rate can depreciate to reduce the size of the deficit.

Dealing with overvalued exchange rate in Euro

The problem is that in the absence of a floating exchange rate it becomes more painful to solve the current account deficit.

To regain competitiveness, Greece and Portugal will have to rely on deflationary policies. For example, higher tax and lower spending to reduce consumer spending on imports. Also by reducing inflation, this makes exports more expensive.

The problem is that it requires a prolonged period of deflation to regain competitiveness. Also, deflation will bring other problems such as low growth, high unemployment.

Overvalued exchange rate in 1920s UK

In 1925, the UK rejoined the gold standard at the same level as pre First World War. It was hoped that the gold standard would give the economy stability and low inflation.

However, economists generally agree the UK joined at the wrong rate. Since the First World War, the UK had seen a decline in competitiveness and the market level of the Pound had fallen.

To keep the value of the Pound at the Gold Standard level of £1 = $4.85, real interest rates needed to be very high. But, high-interest rates led to depressed demand and lower economic growth.

The overvalued exchange rate also make UK exports uncompetitive, leading to a fall in manufacturing output.

Firms responded to over-valued exchange rate by attempting to cut nominal wages. This cut in wages led to the General Strike of 1926.

Partly due to the overvalued exchange rate, the UK experienced high unemployment, low growth - even before the Great Depression.

Real GDP was stagnant in the 1920s.
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Problems of Overvalued Exchange Rate - Economics Help

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An overvalued exchange rate implies that a countries currency is too high for the state of the economy. An overvalued exchange rate means that the countries exports will be relatively expensive and imports cheaper. An overvalued exchange rate tends to depress domestic demand and encourage spending on imports.

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Definition of a Fixed Exchange Rate: This occurs when the government seeks to keep the value of a currency fixed against another currency. e.g. the value of the Pound Sterling fixed against the Euro at £1 = €1.1

Semi-Fixed Exchange Rate. This occurs when the government seeks to keep the value of a currency between a band of the exchange rate. In other words, the exchange rate can fluctuate within a narrow band. For, example the Exchange rate mechanism. For example, the Pound Sterling could fluctuate between a target exchange rate of £1 = €1.05 and £1 = €1.15

UK in Exchange Rate Mechanism

The UK joined the fixed exchange rate mechanism from Oct 1990 to 16 September 1992

The Pound joined at a rate of £1 = DM2.95. But, was allowed a small percentage fluctuations. There was a lower limit of DM 2.773. If the Pound fell below the lower limit, the government would be forced to intervene - raising interest rates and selling foreign currency to buy Pound Sterling.

Definition of a Floating Exchange Rate: this is when the government does not intervene in the foreign exchange market but allows market forces to determine the level of a currency.
Exchange Rate Mechanism ERM
This was a semi-fixed exchange rate where EU countries sought to keep their currencies fixed within certain bands against the D-Mark. The ERM was the forerunner of the Euro

In 1998, the ERM was dissolved as countries prepared to join the Euro. It was replaced with ERM 2 - and countries wishing to join the Euro are required to be part of this for a while.

In 2016, only the Danish krone participates in ERM II.
See also:

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Definition of a Fixed Exchange Rate: This occurs when the government seeks to keep the value of a currency fixed against another currency. e.g. the value of the Pound Sterling fixed against the Euro at £1 = €1.1 Semi-Fixed Exchange Rate.

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AS Economics Revision - Balance of Payments Quiz 1

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The exchange rate is the rate at which one currency trades against another on the foreign exchange market

If the present exchange rate is £1=$1.42, this means that to go to America you would get $142 for £100. Similarly, if an American came to the UK, he would have to pay $142 to get £100. Although in real life, the dealer would make a profit.

Currencies are being continuously traded on the foreign exchange markets, with the prices constantly changing as dealers adjust to changes in supply and demand

Currencies will also undergo long-term changes depending on the state of the comparative countries. E.G. in the 1920s the £ was worth $4.50

Value of the Pound to Dollar 2006-2016. In mid-2008, there was a sharp depreciation in the value of the Pound because the UK was hit very hard by the credit crunch. The Pound also dropped after the Brexit vote in June 2016 because markets were less optimistic about the long-term fortunes of the UK economy outside the EU.
Definitions

Exchange rate index This gives a measure of a currency against a trade-weighted basket of currencies. It is expressed as an index, where the value of the index will be 100 in the base year. The weight given to each currency depends upon the proportion of transactions done with the country. For example, in the Sterling exchange rate index, the highest weighting will be given to the Euro and then the dollar.

Real Exchange Rate. This is the exchange rate after being adjusted for the effects of inflation, it, therefore, more accurately reflects the purchasing power of a currency.

Floating exchange rate - When the value of the currency is determined by market forces - supply and demand for currency

Fixed exchange rate - where the government seeks to keep the value of a currency at a certain level compared to other currencies. See: Fixed Exchange Rates

Determination of exchange rates using supply and demand diagram
In this example, a rise in demand for Pound Sterling has led to an increase in the value of the £ to $
from £1 = $1.50 to £1 = $1.70

Factors influencing exchange rates

Interest rates - higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.

Economic growth - higher economic growth will tend to cause an appreciation in the currency, this is because markets expect higher interest rates - when growth is rapid.

Inflation - higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.

Confidence in the economy/currency.

Current account deficit/surplus. A large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.

See more detail at Factors influencing exchange rates

Appreciation of exchange rate

If the Pound Sterling appreciates in value, the effects will include:

UK exports more expensive abroad - leading to lower demand.

Imports into the UK will be cheaper, increasing demand for imports

An appreciation will tend to reduce inflation,

Lower economic growth - due to reduced demand for exports.

Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)

Strong Pound = Imports Cheaper, Exports Dearer. SPICED

Depreciation / Devaluation

If the Pound devalues then we will see:

UK exports become more competitive, increasing demand for exports

Imports become more expensive, leading to lower demand for imports

A depreciation will tend to increase economic growth but also cause inflation.

Does a devaluation help an economy?

Evaluation of exchange rates

Elasticity of demand. If there is a depreciation in the exchange rate, exports are cheaper, but the amount quantity increases depend on the elasticity of demand. If demand is price inelastic, then a depreciation will have a limited impact in increasing demand and improving economic growth. If demand for exports is elastic, then there will be a big boost to exports.

Time Lag. In the short term, demand for exports is often inelastic but becomes more price elastic over time.

Reasons for depreciation/appreciation. Often it is most successful economies who see appreciation. The currency appreciates because there is more demand for their exports. Therefore, in this case, a depreciation won't cause a fall in economic growth - only limit the growth rate. If the currency appreciates due to speculation, during a period of weak economic growth, then the negative effect on growth may be more pronounced.

More pages on exchange rates

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The exchange rate is the rate at which one currency trades against another on the foreign exchange market If the present exchange rate is £1=$1.42, this means that to go to America you would get $142 for £100. Similarly, if an American came to the UK, he would have to pay $142 to get £100.

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The Exam Performance Specialists | tutor2u

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tutor2u partners with teachers & schools to help students maximise their performance in important exams & fulfill their potential.

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Do you know your dongs from your ringgits? And what currency do they use in Belarus? Try this starter quiz to test your knowledge on foreign currencies.

Name the currency of these countries:

1. Singapore

2. Denmark

3. India

4. Italy

5. South Korea

6. Vietnam

7. Which of these countries does not use the 'dollar' as its currency: Zimbabwe, Hong Kong, Australia, Barbados or Chile?

8. Which country does not use the 'peso' as its currency: Argentina, Brazil, Columbia,, Mexico or Philippines?

9. Which country does not use the 'pound' as its currency: Egypt, Syria, Lebanon, Gibraltar or Nigeria?

10. Which of the following currencies is not pegged to the US dollar: Belarus, Cayman Islands, Cuba, Jordan, Saudi Arabia, Thailand or Hong Kong?

Answers: Dollar, Krone, Rupee, Euro, Won, Dong, Chile, Brazil, Nigeria, Thailand

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Do you know your dongs from your ringgits? And what currency do they use in Belarus? Try this starter quiz to test your knowledge on foreign currencies. Name the currency of these countries: 1. Singapore 2. Denmark 3. India 4. Italy 5. South Korea 6. Vietnam 7.

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Watch this animated guide to find out about why countries are falling out with each other because of their currencies.

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The use of exchange rates in simple business maths calculations is outlined in this revision video.

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AS Economics Revision Webinar: Exchange Rates

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Exchange rates are a core topic for AS Macro. In this revision webinar Geoff Riley guides students through the key analysis and evaluation points students need to consider as they prepare for their exams. Please SUBSCRIBE to the tutor2u YouTube Channel for more revision videos.

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Difference between Depreciation and Devaluation

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A depreciation of the value of the exchange rate happens in a floating currency system whereas a devaluation happens inside a fixed or semi-fixed exchange rate system.The central bank changes the official peg / currency anchor price for official trading. This short revision video clip looks at some recent examples.

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This revision tutorial video looks at some of the macroeconomic effects of a currency depreciation including the impact on the trade balance, economic growth and inflation. It includes an explanation of the J Curve and the Marshall Lerner Condition.

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This topic video looks at some of the factors that can cause a current appreciation or a depreciation in the foreign exchange market.

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This is a Year 1 Macro introduction to the economics of currency markets.