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Rational speculators and exchange rate volatility

  • C.L. Osler
  • John A. Carlson

This paper examines whether rational, fully informed speculators will smooth exchange rates. Friedman's (1953) claim that they must do so is challenged, based on the exclusion of interest rate differentials from his interpretation of speculator behavior. Once one recognizes that interest rates matter to speculators, it becomes apparent that rational speculators could sometimes violate Friedman's description of their behavior, and buy currency when its value is relatively high or sell currency when its value is low. For this reason the presence of rational, fully informed speculators may increase exchange rate volatility under floating exchange rates. Whether or not speculators increase exchange rate volatility depends on the extent of speculative activity and the types of economic shocks that dominate. At low levels of speculative activity, speculation will be stabilizing when the dominant shocks to exchange rates are associated exclusively with real economic activity, such as international trade in goods and services. It becomes destabilizing when the dominant shocks are changes in interest rates, perceived risk, or transactions costs--factors whose influence on exchange rates derives in part from their direct effect on speculators' positions.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 13.

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Date of creation: 1996
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Handle: RePEc:fip:fednsr:13
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  16. Richard K. Lyons., 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," Research Program in Finance Working Papers RPF-230, University of California at Berkeley.
  17. Barry Eichengreen, James Tobin, and Charles Wyplosz., 1994. "Two Cases for Sand in the Wheels of International Finance," Center for International and Development Economics Research (CIDER) Working Papers C94-045, University of California at Berkeley.
  18. Baxter, Marianne & Stockman, Alan C., 1989. "Business cycles and the exchange-rate regime : Some international evidence," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 377-400, May.
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