In the late 1980s, the UK government persisted and started to peg the British pound (GBP) to the German mark (DEM), in the hope that the UK could align itself with the substantially lower inflation rate in Germany. On 8 October 1990, the British government formally entered the pound into the European Exchange Rate Mechanism (ERM) at 2.95 DEM to one GBP and committed to intervene if the exchange rate fluctuates by more than 6%. A. If the exchange rate approaches 2.773 DEM per one GBP, should the Bank of England (BOE) intervene by selling or buying the German marks? Explain briefly. (Hint: first, identify the base currency; second, analyse the BoE's intervention] (2 marks) In order to curb the significant inflationary pressure resulting from the German reunification in 1990, the Deutsche Bundesbank (the German Central Bank) raised short-term interest rates sharply through 1991 and 1992, with the average short-term interest rate climbing from 7.1% in 1989 to 8.5% in 1990, to 9.2% in 1991, and to 9.5% in 1992. B. Should the Bank of England (BOE) raise or reduce its short-term interest rate to keep the currency peg? Use the DR-FR diagram for the FX market equilibrium and the uncovered interest parity (UIP) to explain the mechanism. (3 marks) (hint: distinguish the base currency in the market exchange rate and in the rates specified in the diagram.] Expected Rate of Return (E) G _DR (1) E DEM E DEM-EE/DEM FR: IDEM + spot rate, EDEM FE/DEM Although the BoE's adjustment in short-term interest rates successfully reduced the UK inflation rate from 8% in 1990 to 4.6% in 1992, it also partially dragged the British economy into a severe recession, with an unemployment rate soaring from 6.9% to 10.7%. C. If the UK government intended to deal with economic recession in 1992, should the BoE raise or reduce the interest rate to stimulate consumption and investment demand? Was this option available for the BoE under the ERM? Why? (2 marks) The high unemployment rate posed significant political pressure on the UK government, which made market participants (FX traders, investors, speculators, etc.) suspicious about the government's determination in remaining in the ERM. D. Did market pessimism raise or reduce the expected future exchange rate Elem/e? Had the Bank of England not intervened, would the market spot rate EDEM/E rise or fall? Use the DR-FR diagram and UIP to explain the mechanism. (3 marks) (hint: distinguish the base currency in the market exchange rate and in the rates specified in the diagram.] On Tuesday 15 September 1992, currency traders began a massive sell-off of pounds. In the morning of 16 September 1992, the BoE began accepting orders of 300 million twice before 8:30 am. At 10:30 am, the British government announced an increase in the base interest rate, from 10%, to 12% to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15%, dealers kept selling pounds. By 7:00pm, it was announced Britain would leave the ERM and rates would remain at the new level of 12%; on the next day the interest rate was back to 10%. E. Why did the Boe's large-scale purchase of the GBP and interest rate hike fail to stop the selling of pounds in the FX market? Use the DR-FR diagram and VIP to explain the mechanism. Why did the market interest rate fall after UK left the ERM? Was it consistent with market expectations before