Lecture 13 - Lecture 13 Speculative attacks The last main...

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Lecture 13 Speculative attacks The last main topic I want to bring up today is whether speculators can bring about exchange rate fluctuations. The basic point I want to make is that speculators can’t bring them about by themselves. There has to be an underlying weakness or vulnerability in the real economy to make it possible for speculators to act. The case of England. I want to start by reviewing the mechanisms of high and low exchange rates in one historical context. In 1992, the British government was committed to keeping the British pound at a more or less fixed rate compared with other European currencies. The government selected a high exchange rate. As we saw last time, a high rate makes exports less competitive abroad, and imports were cheap in England. Imports flooded into England, and English exports declined, so production and employment declined. The belief spread that the peg would be lifted in order to solve this problem, and as the belief spread people sold the pound—if you think an asset will decline in price you want to sell it before the decline takes place. This of course made it more difficult to defend the peg, and the Bank of England had to offer high interest rates to attract money into England. This is an example of the two legs out of three we were discussing before: open capital flows and a pegged rate meant the interest rate tool had to be deployed . But raising rates made a bad situation worse. Since the British economy was already depressed, the best thing to do would have been to cut interest rates to stimulate business. To maintain the fixed exchange rate, the Brits instead had to offer high interest rates, which further contributed to the business slowdown. Eventually domestic political pressures to cut interest rates became too strong, and the British government cut interest rates and the pound depreciated. Again, if you want to have money coming in and out freely, you have to choose between defending the exchange rate, and using the interest rate to help the defense, or using the interest rate to the best advantage in the domestic economy; you can’t control both the exchange rate and the interest rate if you’re open to outside capital flows. The case of Thailand. Article 12.2 brings up th e devaluation of the Thai baht in 1997, which began the East Asian financial crisis. The article says “investors started to have doubts about whether the Thai government would be able to maintain the value of the baht against the US dollar. They began to sell the local currency, betting that the government would eventually have to devalue. After defeating the Thai peg, in other words forcing the Thai government to devalue, they turned to other countries is Asia. Successful attacks were mounted against Indonesia, Malaysia and South Korea.”
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Lecture 13 - Lecture 13 Speculative attacks The last main...

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