Rational Speculators and Exchange Rate Volatility
European Economic Review
Posted: 22 Apr 1998
This paper examines whether rational, fully informed speculators stabilize floating exchange rates. Friedman's claim that they must do so (1953), because they buy low and sell high, is challenged. Friedman excluded any consideration of interest rate differentials from his interpretation of speculator behavior. We show that, if interest differentials affect speculators' profits, rational speculative activity can increase exchange-rate volatility. Since they do this by changing the exchange rate's generating process, the connection between rational speculation and exchange rate volatility highlighted here can be considered microstructural. Low levels of rational speculation are stabilizing and high levels are destabilizing.
JEL Classification: F31
Suggested Citation: Suggested Citation