Abstract
Between August 25, 1939 and June 7, 1940, there was a free market for British pounds in New York. German success at the outset of World War II caused the value of free sterling to fall relative to the official exchange rate. This imposed an externality that made it more difficult for Britain to finance the war. Eventually, the externality became large enough that Britain chose to take extreme measures to abolish it, even at the expense of tarnishing the reputation of London’s financial markets. We collected daily data to investigate how the market reacted to war news and to policy changes. Using methods developed by Bai and Perron (Econometrica 66:47–78, 1998; Journal of Applied Econometrics 18:1–22, 2003), we find 17 breaks in the exchange rate. Fourteen are associated with military events and three are associated with policy changes. The episode illustrates how markets can fail to serve the public interest during times of war.
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