To defend the fixed exchange rate, the Riksbank raised the repo rate. During 1990–1991 the major tax reform was implemented, which meant that tax deductions declined significantly. All in all, the real interest rate after tax rose very substantially over a short period of time, which subdued the demand for credit substantially, and property prices took a sharp downturn. The end result of this process was a banking crisis. The banking crisis also led to a dramatic deterioration in public finances. At the same time, there was a currency crisis in Europe. Sweden had abolished currency regulation in 1989 and in 1991 pegged the krona to the ecu, the euro’s predecessor. However, partly as a result of the higher interest rates in Germany, an increasing number of countries in the European Exchange Rate Mechanism, ERM, experienced a depreciation pressure on their currencies. The previous history of devaluations also meant that there was even greater pressure for another Swedish devaluation. In an attempt to defend the fixed exchange rate, the Riksbank raised its policy rate to a massive 500 per cent. Finally, the situation became untenable and the fixed exchange rate was abandoned on 19 November 1992. The route to the 500-per cent interest rate was thus part of a longer sequence of events, with several interacting circumstances. It also provides a clear illustration of what can happen when the confidence in the nominal anchor is lost.
The stronger exchange rate pushes down net exports and thus general demand and GDP. If the international interest rate falls instead, and monetary policy in Sweden is held unchanged, the exchange rate will also strengthen, because the Swedish interest rate is higher than the international rate. The currency will appreciate until the domestic interest rate is the same as the international interest rate, and the stronger exchange rate will lead to reduced net export and GDP. We thus see that a lower international interest rate has a restraining effect on the economy through the exchange rate in roughly the same way as a tightening of monetary policy in Sweden. As I mentioned earlier, this model is a very simplified picture of reality. In practice, the results will of course depend on why the interest rates are changing and also on other factors not included in the simple model. But the conclusion, that a lower international interest rate has a restraining effect on the economy through the exchange rate in roughly the same way as a tightening of monetary policy in Sweden, is valid even in many more complicated models. The effect of lower international interest rates on the Swedish exchange rate and the Swedish economy has been discussed a lot at monetary policy meetings in recent years, although the discussion has revolved around the effects on inflation in Sweden and not the real economy.