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Rational Speculative Bubbles in an Exchange Rate Target Zone

  • Willem H. Buiter
  • Paolo A. Pesenti

The recent theory of exchange rate dynamics within a target zone holds that exchange rates under a currency bard 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 setup in which the existence of speculative behavior is a datum the Central Bank has to deal with. We show that the defense 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. These results hold for a large class of exogenous and fundamental-dependent bubble processes. We show that the instantaneous volatility of exchange rates within a bard is not necessarily less than the volatility under free float and analyze the implications for interest rate differential dynamics.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3467.

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Date of creation: Oct 1990
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Handle: RePEc:nbr:nberwo:3467
Note: ITI IFM
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  8. 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.
  9. McCallum, Bennett T., 1983. "On non-uniqueness in rational expectations models : An attempt at perspective," Journal of Monetary Economics, Elsevier, vol. 11(2), pages 139-168.
  10. Svensson, Lars E O, 1991. "The Simplest Test of Target Zone Credibility," CEPR Discussion Papers 493, C.E.P.R. Discussion Papers.
  11. Bertola, G. & Cabarello, R.J., 1990. "Target Zones And Realignments," Discussion Papers 1990_51, Columbia University, Department of Economics.
  12. Frank Hahn, 1985. "Money and Inflation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262580624, June.
  13. 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.
  14. Buiter, Willem H, 1989. "A Viable Gold Standard Requires Flexible Monetary and Fiscal Policy," Review of Economic Studies, Wiley Blackwell, vol. 56(1), pages 101-17, January.
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  17. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  18. Paul Krugman & Julio Rotemberg, 1990. "Target Zones with Limited Reserves," NBER Working Papers 3418, National Bureau of Economic Research, Inc.
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  20. 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.
  21. 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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  24. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  25. 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.
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