Recent theories of exchange rate behaviour hold that exchange rates are less responsive to fundamental shocks under a currency band regime than under a free float, provided that the monetary authorities' intervention rules are common knowledge. Moreover, there is always a trade-off between the instantaneous volatility of changes in exchange rates and changes in the interest rate differential, independent of the size of the band and the credibility of the target zone. These results derive from the a priori assumption that there is no `rational excess volatility' (due to so-called `rational bubbles') in foreign exchange markets, i.e. that speculative bubbles are incompatible with the existence and persistence of a credible target zone, and therefore never materialize.

In Discussion Paper No. 488, Research Fellow Willem Buiter and Paolo Pesenti take speculative behaviour as a datum. They show that the existence of a target zone and the presence of rational bubbles are compatible, and that the intervention rules that should be followed by the Central Bank when speculative bubbles arise include as a special case the traditional policies for defending an exchange rate band when there are no speculative bubbles.

In the standard model, the authorities defend the target zone through intermittent variations in domestic credit and/or non- sterilized foreign exchange market interventions when the exchange rate hits one of the limits of the band. Heuristically, these operations can be characterized as infinitesimal reflecting interventions: although the size of the reflecting operations may be quantitatively limited, the induced expectations stabilize the exchange rate even before the upper or lower limit is reached.

Buiter and Pesenti show that reflecting interventions are insufficient in the cum bubble set-up, and speculative bubbles necessarily lead to speculative attacks on the target zone as well. These stock-shift reshuffles of private agents' financial portfolios are led by rational expectations of changes in the rate of exchange rate depreciation. The target zone is guaranteed if the Central Bank accommodates speculative attacks when the latter are `friendly', or consistent with the target zone's survival. This intuitive policy rule is compatible with self-fulfilling expectations: a friendly attack occurs only if agents know that it will be accommodated, and it is precisely because of this passive accommodation that the speculative attack sustains the target zone.

Many of the models in the existing literature are not robust to the inclusion of speculative bubbles, since the behaviour of rational speculative bubbles and hence of the exchange rate under a free float is inherently explosive. This has led many authors to rule out speculative bubbles under a free float, but Buiter and Pesenti find that exchange rate behaviour is not explosive when the target zone is credible, so there is no reason to rule out bubbles.

Buiter and Pesenti then show that in their model the instantaneous volatility of exchange rates within a band is not necessarily less than under free float, and that the relationship between the exchange rate and the interest differential need not be negative, even if the target zone is fully credible.

Rational Speculative Bubbles in an Exchange Rate Target Zone
Willem H Buiter and Paolo A Pesenti

Discussion Paper No. 479, November 1990 (IM)