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Rational Speculative Bubbles in an Exchange Rate Target Zone

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  • Buiter, Willem H
  • Pesenti, Paolo

Abstract

The recent theory of exchange rate dynamics within a target zone holds that exchange rates under a currency band are less responsive to fundamental shocks than exchange rates under a free float, provided that the intervention rules of the Central Bank(s) are common knowledge. These results are derived after having assumed a priori that excess volatility due to rational bubbles does not occur in the foreign exchange market. In this paper we consider instead a set-up in which the existence of speculative behaviour is a datum with which the central bank has to deal. We show that the defence of the target zone in the presence of bubbles is viable if the Central Bank accommodates speculative attacks when the latter are consistent with the survival of the target zone itself and expectations are self-fulfilling. We show that the instantaneous volatility of exchange rates within a bank is not necessarily less than the volatility under free float. There need not be a constant tradeoff between the volatility of the change in the exchange rate and the volatility of the change in the interest rate differential. Fundamental-dependent bubbles can account for the excess response of the exchange rate to the fundamental. The relationship between the exchange rate and the interest differential need not be negative, even if the target zone is fully credible.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 479.

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Date of creation: Nov 1990
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Handle: RePEc:cpr:ceprdp:479

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Keywords: Bubbles; Exchange Rates; Target Zones;

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References

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  1. Buiter, W., 1988. "A Viable Gold Standard Requires Flexible Monetary And Fiscal Policy," Papers 306, London School of Economics - Centre for Labour Economics.
  2. Delgado, F. & Dumas, B., 1990. "Monetary Contracting Between Central Banks And The Design Of Sustainable Exchange-Rate Zones," Weiss Center Working Papers 20-90, Wharton School - Weiss Center for International Financial Research.
  3. Bennett T. McCallum, 1981. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc.
  4. Francisco Delgado & Bernard Dumas, 1990. "Monetary Contracting Between Central Banks and the Design of SustainableExchange-Rate Zones," NBER Working Papers 3440, National Bureau of Economic Research, Inc.
  5. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  6. Lars E. O. Svensson, 1991. "The Simplest Test of Target Zone Credibility," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 655-665, September.
  7. Farmer, Roger E.A. & Woodford, Michael, 1997. "Self-Fulfilling Prophecies And The Business Cycle," Macroeconomic Dynamics, Cambridge University Press, vol. 1(04), pages 740-769, December.
  8. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-36, June.
  9. Klein, Michael W, 1990. "Playing with the Band: Dynamic Effects of Target Zones in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(4), pages 757-72, November.
  10. Sutherland, A. & Miller, M., 1990. "Britain'S Return To Gold And Impending Entry Into The Ems: Expectations, Joining Conditions And Credibility," The Warwick Economics Research Paper Series (TWERPS) 361, University of Warwick, Department of Economics.
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  12. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Stochastic Process Switching: Some Simple Solutions," Econometrica, Econometric Society, vol. 59(1), pages 241-50, January.
  13. Paul Krugman & Julio Rotemberg, 1990. "Target Zones with Limited Reserves," NBER Working Papers 3418, National Bureau of Economic Research, Inc.
  14. Kenneth A. Froot & Maurice Obstfeld, 1989. "Intrinsic Bubbles: The Case of Stock Prices," NBER Working Papers 3091, National Bureau of Economic Research, Inc.
  15. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  16. Grandmont Jean-michel, 1983. "On endogenous competitive business cycles," CEPREMAP Working Papers (Couverture Orange) 8316, CEPREMAP.
  17. Behzad T. Diba & Herschel I. Grossman, 1988. "Rational Inflationary Bubbles," NBER Working Papers 2004, National Bureau of Economic Research, Inc.
  18. Francisco Delgado & Bernard Dumas, . "Monetary Contracting between Central Banks and the Design of Sustainable Exchange-Rate Zones (Reprint 035)," Rodney L. White Center for Financial Research Working Papers 20-90, Wharton School Rodney L. White Center for Financial Research.
  19. Karen K. Lewis, 1990. "Occasional Interventions to Target Rates with a Foreign Exchange Application," NBER Working Papers 3398, National Bureau of Economic Research, Inc.
  20. Frank Hahn, 1985. "Money and Inflation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262580624, December.
  21. Paul R. Krugman, 1987. "Trigger Strategies and Price Dynamics in Equity and Foreign Exchange Markets," NBER Working Papers 2459, National Bureau of Economic Research, Inc.
  22. Chiappori, Pierre Andre & Guesnerie, Roger, 1988. "Endogenous fluctuations under rational expectations," European Economic Review, Elsevier, vol. 32(2-3), pages 389-397, March.
  23. Miller, M. & Weller, P., 1988. "Solving Stochastic Saddlepoint Systems: A Qualitative Treatment With Economic Applications," The Warwick Economics Research Paper Series (TWERPS) 309, University of Warwick, Department of Economics.
  24. Flood, Robert P & Garber, Peter M, 1991. "The Linkage between Speculative Attack and Target Zone Models of Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1367-72, November.
  25. Delgado, F. & Dumas, B., 1990. "Monetary Contracting Between Central Banks And The Design Of Sustainable Exchange-Rate Zones," The Warwick Economics Research Paper Series (TWERPS) 360, University of Warwick, Department of Economics.
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Citations

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Cited by:
  1. Buiter, Willem H, 2008. "Housing Wealth isn't Wealth," CEPR Discussion Papers 6920, C.E.P.R. Discussion Papers.
  2. Buch, Claudia M. & Koop, Michael J. & Schweickert, Rainer & Wolf, Hartmut, 1995. "Währungsreformen im Vergleich : monetäre Strategien in Rußland, Weißrußland, Estland und der Ukraine," Open Access Publications from Kiel Institute for the World Economy 831, Kiel Institute for the World Economy (IfW).
  3. Antoine Magnier, 1992. "Théorie des zones cibles et fonctionnement du SME," Économie et Prévision, Programme National Persée, vol. 104(3), pages 87-113.
  4. Simon van Norden, 1995. "Regime Switching as a Test for Exchange Rate Bubbles," Econometrics 9502001, EconWPA, revised 09 Aug 1995.

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