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Rational Speculative Bubbles in an Exchange Rate Target Zone

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Author Info
Buiter, Willem H
Pesenti, Paolo

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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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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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Related research
Keywords: Bubbles; Exchange Rates; Target Zones;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Karen K. Lewis, 1990. "Occasional Interventions to Target Rates with a Foreign Exchange Application," NBER Working Papers 3398, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. 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.
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  3. 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.
  4. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-36, June. [Downloadable!] (restricted)
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  5. 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. [Downloadable!]
  6. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389. [Downloadable!] (restricted)
  7. 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. [Downloadable!] (restricted)
  8. Robert P. Flood & Peter M. Garber, 1989. "The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates," NBER Working Papers 2918, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. 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.
  10. 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.
  11. Buiter, W., 1988. "A Viable Gold Standard Requires Flexible Monetary And Fiscal Policy," Papers 306, London School of Economics - Centre for Labour Economics.
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  12. Diba, Behzad T. & Grossman, Herschel I., 1988. "Rational inflationary bubbles," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 35-46, January. [Downloadable!] (restricted)
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  13. 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. [Downloadable!] (restricted)
  14. Grandmont, Jean-Michel, 1985. "On Endogenous Competitive Business Cycles," Econometrica, Econometric Society, vol. 53(5), pages 995-1045, September. [Downloadable!] (restricted)
  15. Bennett T. McCallum, 1983. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall. [Downloadable!]
  17. Chiappori, Pierre Andre & Guesnerie, Roger, 1988. "Endogenous fluctuations under rational expectations," European Economic Review, Elsevier, vol. 32(2-3), pages 389-397, March. [Downloadable!] (restricted)
  18. Svensson, L.E.O., 1989. "Target Zones And Interest Rate Variability," Papers 457, Stockholm - International Economic Studies.
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  19. 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. [Downloadable!] (restricted)
  20. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Stochastic Process Switching: Some Simple Solutions," Econometrica, Econometric Society, vol. 59(1), pages 241-50, January. [Downloadable!] (restricted)
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  21. Paul Krugman & Julio Rotemberg, 1990. "Target Zones with Limited Reserves," NBER Working Papers 3418, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  22. 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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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dorofeev Evgeny, 2000. "Economic Factors Influence on the Russian Capital Market Behavior," EERC Working Paper Series 2k-03e, EERC Research Network, Russia and CIS. [Downloadable!]
  2. Simon van Norden, 1995. "Regime Switching as a Test for Exchange Rate Bubbles," Econometrics 9502001, EconWPA, revised 09 Aug 1995. [Downloadable!]
    Other versions:
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