AP_Krugman_Textbook

module 44 Exchange Rates and Macroeconomic Policy 441

The Joy of a Devalued Pound

The Exchange Rate Mechanism is the system of

European fixed exchange rates that paved the

way for the creation of the euro in 1999. Britain

joined that system in 1990 but dropped out in

1992. The story of Britain’s exit from the Ex-
      change Rate Mechanism is a classic example of
      open -economy macroeconomic policy.
      Britain originally fixed its exchange rate for
      both the reasons we described earlier: British
      leaders believed that a fixed exchange rate
      would help promote international trade, and
      they also hoped that it would help fight inflation.
      But by 1992 Britain was suffering from high un-
      employment: the unemployment rate in Sep-
      tember 1992 was over 10%. And as long as the
      country had a fixed exchange rate, there wasn’t
      much the government could do. In particular,
      the government wasn’t able to cut interest rates
      because it was using high interest rates to help
      support the value of the pound.
      In the summer of 1992, investors began spec-
      ulating against the pound—selling pounds in the

expectation that the currency would drop in

value. As its foreign reserves dwindled, this spec-

ulation forced the British government’s hand. On

September 16, 1992, Britain abandoned its fixed

exchange rate. The pound promptly dropped 20%

against the German mark, the most important

European currency at the time.

At first, the devaluation of the pound greatly

damaged the prestige of the British government.

But the Chancellor of the Exchequer—the equiv-

alent of the U.S. Treasury Secretary—claimed to

be happy about it. “My wife has never before

heard me singing in the bath,” he told reporters.

There were several reasons for his joy. One was

that the British government would no longer have

to engage in large -scale exchange market inter-

vention to support the pound’s value. Another was

that devaluation increases aggregate demand, so

the pound’s fall would help reduce British unem-

ployment. Finally, because Britain no longer had a

fixed exchange rate, it was free to pursue an ex-

pansionary monetary policy to fight its slump.

fyi

Indeed, events made it clear that the chan-

cellor’s joy was well founded. British unemploy-

ment fell over the next two years, even as the

unemployment rate rose in France and Ger-

many. One person who did not share in the im-

proving employment picture, however, was the

chancellor himself. Soon after his remark about

singing in the bath, he was fired.

Photodisc

Module 44 AP Review

Check Your Understanding

1. Look at the graph in the FYI section on page 438. Where do you
   see devaluations and revaluations of the franc against the mark?


2. In the late 1980s, Canadian economists argued that the high
   interest rate policies of the Bank of Canada weren’t just causing
   high unemployment—they were also making it hard for

Canadian manufacturers to compete with U.S. manufacturers.

Explain this complaint, using our analysis of how monetary

policy works under floating exchange rates.

Solutions appear at the back of the book.

Tackle the Test: Multiple-Choice Questions

1. Devaluation of a currency occurs when which of the following
   happens?
   I. The supply of a currency with a floating exchange rate
   increases.
   II. The demand for a currency with a floating exchange rate
   decreases.
   III. The government decreases the fixed exchange rate.

a. I only

b. II only

c. III only

d. I and II only

e. I, II, and III