Chaos in the Currency Markets : Currency Crisis of the Ems

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Chaos in The Currency Markets : Currency Crisis of The EMS

1. What does the crisis of September 1992 tell you about the relative abilities of currency markets and national governments to influence exchange rates?

The currency markets and national governments both have abilities to influence exchange rates. Like other financial markets, foreign exchange markets react to any news that may have a future effect. Speculators are the part of the currency markets that take currency positions based on anticipated interest rate movements in various countries. Day-to-day speculation on future exchange rate movements is commonly driven by signals of future interest rate movements. By using the signal, speculators usually take the position before the things actually occurred. Sometime, if high power enough, the speculators position can influence the exchange rate movement. The government controls is one of the factors affecting exchange rate. The government can influence the equilibrium exchange rate in many way, including direct intervening (buying and selling currencies) in the foreign exchange markets and indirect intervening by affecting macro variables such as interest rates.

2. What does the crisis of September 1992 tell you about the weakness of fixed exchange rate regimes?

From European currency crisis of September 1992, it shows us that there are weakness of the fixed exchange rate system. When exchange rate are tied, a high interest rate in one country has a strong influence on interest rates in the other countries. Funds will flow to the country with a more attractive interest rate, which reduces the supply of fund in the other countries and places upward pressure on their interest rates. The flow of fund would continue until the interest rate differential has been eliminated or reduced. This process would not necessarily apply to countries outside ERM that do not in the fixed exchange rate system, because the exchange rate risk may discourage the...
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