Page 483 - Krugmans Economics for AP Text Book_Neat

fyi

The Joy of a Devalued Pound
The Exchange Rate Mechanism is the system of expectation that the currency would drop in
European fixed exchange rates that paved the value. As its foreign reserves dwindled, this spec-
way for the creation of the euro in 1999. Britain ulation forced the British government’s hand. On
joined that system in 1990 but dropped out in September 16, 1992, Britain abandoned its fixed
1992. The story of Britain’s exit from the Ex- exchange rate. The pound promptly dropped 20%
change Rate Mechanism is a classic example of against the German mark, the most important
open -economy macroeconomic policy. European currency at the time.
Britain originally fixed its exchange rate for At first, the devaluation of the pound greatly
both the reasons we described earlier: British damaged the prestige of the British government.
leaders believed that a fixed exchange rate But the Chancellor of the Exchequer—the equiv-
would help promote international trade, and alent of the U.S. Treasury Secretary—claimed to
Photodisc
they also hoped that it would help fight inflation. be happy about it. “My wife has never before
But by 1992 Britain was suffering from high un- heard me singing in the bath,” he told reporters.
employment: the unemployment rate in Sep- There were several reasons for his joy. One was
tember 1992 was over 10%. And as long as the that the British government would no longer have Indeed, events made it clear that the chan-
country had a fixed exchange rate, there wasn’t to engage in large -scale exchange market inter- cellor’s joy was well founded. British unemploy-
much the government could do. In particular, vention to support the pound’s value. Another was ment fell over the next two years, even as the
the government wasn’t able to cut interest rates that devaluation increases aggregate demand, so unemployment rate rose in France and Ger-
because it was using high interest rates to help the pound’s fall would help reduce British unem- many. One person who did not share in the im-
support the value of the pound. ployment. Finally, because Britain no longer had a proving employment picture, however, was the
In the summer of 1992, investors began spec- fixed exchange rate, it was free to pursue an ex- chancellor himself. Soon after his remark about
ulating against the pound—selling pounds in the pansionary monetary policy to fight its slump. singing in the bath, he was fired.

Module 44 AP Review

Solutions appear at the back of the book.
Check Your Understanding

1. Look at the graph in the FYI section on page 438. Where do you Canadian manufacturers to compete with U.S. manufacturers.
see devaluations and revaluations of the franc against the mark? Explain this complaint, using our analysis of how monetary
policy works under floating exchange rates.
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

Tackle the Test: Multiple-Choice Questions
1. Devaluation of a currency occurs when which of the following a. I only
happens? b. II only
I. The supply of a currency with a floating exchange rate c. III only
increases. d. I and II only
II. The demand for a currency with a floating exchange rate e. I, II, and III
decreases.
III. The government decreases the fixed exchange rate.

module 44 Exchange Rates and Macroeconomic Policy 441