Speculative attack

Definition

A speculative attack occurs when investors sell off a currency in anticipation that it will decline in value, leading to a rapid depreciation of that currency. This action is often driven by concerns about the economic fundamentals of a country, political instability, or unsustainable exchange rate policies, and can create a self-fulfilling prophecy as the attack forces the central bank to deplete its reserves or alter its currency policy.

5 Must Know Facts For Your Next Test

1. Speculative attacks are often triggered by rumors or negative news about a country’s economy, which can lead investors to withdraw their support rapidly.
2. When a speculative attack occurs, the central bank may intervene by using its foreign exchange reserves to support the currency, but this can only be sustained for so long.
3. The most famous speculative attack occurred in 1992 when George Soros famously short-sold the British pound, contributing to its exit from the European Exchange Rate Mechanism.
4. Speculative attacks can lead to severe economic consequences, including inflation, loss of investor confidence, and even the collapse of an economy's financial system.
5. Governments may attempt to prevent speculative attacks through policies such as increasing interest rates or implementing capital controls, but these measures can have mixed results.

Review Questions

• How do speculative attacks affect a country's monetary policy and economic stability?
  • Speculative attacks can significantly disrupt a country's monetary policy and economic stability by forcing central banks to deplete their foreign exchange reserves to defend the currency. This often leads to increased interest rates as governments attempt to attract foreign capital and stabilize the currency. As confidence erodes, speculative behavior can escalate, leading to rapid capital flight and exacerbating economic instability.
• Evaluate the role of investor sentiment in triggering speculative attacks on currencies and its implications for international financial markets.
  • Investor sentiment plays a crucial role in triggering speculative attacks since negative perceptions about a country's economic health can prompt mass selling of its currency. This creates a feedback loop where declining currency values lead to further pessimism among investors, resulting in more selling pressure. The implications for international financial markets are significant, as these attacks can lead to increased volatility and uncertainty, impacting global trade and investment flows.
• Analyze the long-term effects of a successful speculative attack on a nation's economy and its position in global financial markets.
  • A successful speculative attack can have long-term detrimental effects on a nation's economy, such as diminished investor confidence, higher borrowing costs, and potential economic recession. The attack may lead to structural changes in fiscal and monetary policies as governments attempt to restore stability and credibility. Additionally, it can alter the nation’s position in global financial markets by making it less attractive for foreign investment and increasing vulnerability to future attacks due to perceived weaknesses in economic fundamentals.

Related terms

Currency Peg: A currency peg is a policy where a country's currency value is tied to another major currency or a basket of currencies to maintain stability.

Exchange Rate Mechanism: An exchange rate mechanism is a system that determines how much one currency can be exchanged for another, influencing international trade and investment.

Central Bank Intervention: Central bank intervention refers to actions taken by a country's central bank to stabilize or influence the value of its currency in the foreign exchange market.