British Pound Crisis 1992

Table of Content

Question 1 .........................................................................................................................1

Question 2. ........................................................................................................................2

Question 3. ........................................................................................................................4

Question 4 .........................................................................................................................6

References .........................................................................................................................8

Question 1: Describe the crisis scenario around the British Pound in

summer 1992 applying the theory of speculative attacks, as discussed in class

and class notes. Which model applies best and why?

The crisis scenario of the British Pound in summer 1992 follows the “second generation

model”. In the years before the crisis, Great Britain had a relative low inflation rate

(1989: 5.2 %), a fiscal surplus (1989: around 0.5 % of GDP) and low government debt

of less than 30 % in 1989 (National Statistics Online, accessed December 26th, 2010). In

October 1990, Great Britain entered the European Exchange Rate Mechanism (ERM),

presumably aimed to keep the inflation down as Britain’s inflation rate had risen to

around 9 % in 1990. Upon entering the ERM, the British Pound was pegged to the

Deutsche Mark at around 2.95 Deutsche Mark for 1 British Pound. The ERM allowed

the exchange rate of the British Pound to float within a band of 2.25 % around the

central rate. If the exchange rate had hit the upper or lower limit of the band, the central

bank would have been obligated to intervene. Great Britain had a good reason to keep

the peg because of their political commitment to the international cooperation in Europe

and the forthcoming establishment of the European Monetary System....