Rational Speculators and Exchange Rate Volatility

31 Pages Posted: 22 Jun 2007

See all articles by Carol L. Osler

Carol L. Osler

Brandeis University - International Business School

John A. Carlson

Purdue University - Department of Economics

Date Written: May 1996

Abstract

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.

Keywords: exchange rate, volatility

JEL Classification: F30, F31

Suggested Citation

Osler, Carol L. and Carlson, John A., Rational Speculators and Exchange Rate Volatility (May 1996). FRB of New York Staff Report No. 13. Available at SSRN: https://ssrn.com/abstract=993856 or http://dx.doi.org/10.2139/ssrn.993856

Carol L. Osler (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States
781-736-4826 (Phone)

John A. Carlson

Purdue University - Department of Economics ( email )

Krannert School of Management
West Lafayette, IN 47907-1310
United States

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