West Germany’s Undervalued Exchange Rate

West Germany’s Undervalued Exchange Rate

The Bundesbank, the German central bank, was committed under the Bretton Woods system to defending a par exchange rate of $0.27 per deutsche mark (DM). Because this exchange rate was lower than what the equilibrium market exchange rate would have been, there was a shortage of DMs in the foreign exchange market. The Bundesbank had to supply DMs equal to the shortage in exchange for dollars. The shortage in the figure is equal to 1 billion DMs per day.

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Capital controls Limits on the flow of foreign exchange and financial investment across countries.

Figure 19A-3

Destabilizing Speculation against the Deutsche Mark, 1971

In 1971, the par exchange rate of $0.27 = 1 deutsche mark was below the equilibrium exchange rate of $0.35 = 1 deutsche mark. As investors became convinced that West Germany would have to revalue the deutsche mark, they increased their demand for marks from D1 to D2. The new equilibrium exchange rate became $0.42 = 1 deutsche mark. This increase in demand raised the quantity of marks the Bundesbank had to supply in exchange for dollars to defend the par exchange rate from 1 billion deutsche marks to 2 billion deutsche marks per day.

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