Speculative Attack

European countries ran into.the fundamental contradiction in the early 1990s when their exchange stem were attacked by speculators who believed that countries wouldn’t tolerate overvalued exchange rates and too high interest rates indefinitely. One ‘by one, currencies came under attack-the Finnish mark, the Swedish crown, the Italian lira, the British pound, the Spanish peseta. In the end, only the inner sanctum of France and Germany withstood the speculative attacks; This episode shows a corollary of the fundamental contradiction: A fixed-exchange-rate system is prone to devastating speculative attack if financial capital flows freely amQng countries.

The reason is the following: A fixed but adjustable exchange rate is susceptible to attack whenever speculators believe that changes in the exchange rate are imminent. If a currency is likely to .he devalued, speculators will quickly start selling that Clarence}’.The supply of the currency increases while demand drops, At this point, central hanks step in to defend the currency (recall the graphical description of inter   in Figure 29-8 on page 629). But given the private resources available for speculative attacks easily tens of billions of dollars in a few hours-the defender of a .weak currency quickly runs out of reserves. Unless “hard-currency” countries are willing to provide unlimited lines -of credit, the defending central bank will sooner or later give up and either devalue or allow the currency to float.

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