Explain the 1992 crisis that led to the breakdown of the European Union's Exchange Rate Mechanism. What disadvantages of exchange-rate targeting were exhibited during this crisis?

What will be an ideal response?

The 1992 crisis began with Germany raising interest rates in 1990 to stem inflationary pressures from reunification. This demand shock was immediately transmitted to the other nations in the exchange-rate mechanism. Thus, these countries did not have independent monetary policies and were subject to shocks from the anchor country. This gave rise to the second problem. Speculators bet that these other countries would not want the increased unemployment resulting from the tight monetary policy. Betting that their commitment was weak, speculators bet against these currencies, and a number were forced to devalue or drop out of the ERM. The disadvantages illustrated by this are the lack of independent policy subjecting member nations to shocks from the anchor nation, and the possibility of speculative attacks when commitment is felt to be weak.