Speculation under floating rates is likely to be d...

Speculation under floating rates is likely to be destabilizing

The major argument advanced against floating exchange rates is that they are likely to be characterized by destabilizing private speculation producing the “wrong” exchange rate and by which is meant a sub-optimal rate from the viewpoint of resource allocation.These are several ways in which private speculation can bring about the wrong exchange markets; some of the arguments depend on “irrational” speculation while others depend upon uncertainty.

One example of irrational speculation frequently cited is that foreign exchange market participants can be too risk averse.They attach too high a probability to the possibility of a depreciation of a “weak” currency, or equivalently too high a probability to the possibility of an appreciation of a “strong” currency even when this is not justified by the fundamentals.That is, one currency, say the pound sterling, is regarded as “too risky” while another, say the US dollar, is regarded as “safe”—market participants are basing their exchange-rate forecasts not only on currently available information but also past performance.The result is that there may be an unjustified reluctance to move out of dollars and to hold pounds, so that there is a larger depreciation of the pound that is justified by the fundamentals required as a premium by speculations to hold the pound.As a result the dollar becomes overvalued, while the pound becomes undervalued.The argument does not imply that risk-aversion is an inefficient feature of the foreign exchange market, but rather that excessive risk-aversion unjustified by the fundamentals is.Instability of a country’s economic policies may well create uncertainty and therefore risk concerning estimates about the correct value of its currency.Excessive risk-aversion, however, implies that part of the risk premium required by the market is unjustified by the fundamentals.

Another case where irrational private speculation can produce the wrong rate is via the “bandwagon” effect.The idea is that there is too much self-generating speculation detached from the fundamentals, “speculation feeding upon speculation” rather than the fundamentals.A possible scenario involving the bandwagon effect is when some news hits the market, say an unexpected increase in the UK money supply, which then sets off unjustified speculation that the eventual rate of monetary growth will be even greater bringing with it an unduly pessimistic inflation forecast.Assuming that the rate of growth of the money supply contained in the news turns out to be the actual rate, the depreciation of the pound will turn out to have been greater than was justified by the news and this will then reverse itself when it becomes evident that a bandwagon effect has been in play.

The excessive risk-aversion and bandwagon-effect arguments presuppose that foreign exchange speculators do not use all the information and news available to them efficiently, and consequently speculation produces the wrong exchange rate until eventually fundamentals reassert themselves.More recently, authors such as Dornbusch (1983)have emphasized reasons as to why even rational speculators can produce the “wrong” exchange rate.These explanations are all based upon the concept of exchange-rate uncertainty.

One reason why rational speculators may produce the wrong exchange rate is that in a world of uncertainty they do not know the correct exchange-rate model and as such they use a seriously defective model.Their expectations based on the wrong (irrelevant)exchange-rate model will then generally lead to the wrong exchange rate.This point is important because market participants may be impressed by a plausible but relatively unimportant fundamental variable, and make their expectations based upon movements in that variable come true.Furthermore, changes in irrelevant variables may lead to significant exchange-rate movements.A further danger is that economic agents may shift their attention between many irrelevant pieces of information, causing excessive exchange-rate variability and even major collapses of the rate.

Another reason why rational speculators may produce the wrong exchange rate is known as the “Peso Problem”.Exchange rates are determined not only by what is held to be the underlying fundamentals today, but by what is expected to happen to those fundamentals in the future.Even if speculators’ models of the underlying fundamentals are correct, their perceptions about the future can prove to be seriously wrong.In such cases the exchange rate moves immediately in anticipation of events that do not materialize.Such ex post unjustified exchange-rate movements can seriously interfere with the conduct of macroeconomic policy and with it macroeconomic stability.

Another reason for rational speculation producing the wrong rate has been proposed by Blanchard (1979)known as a “rational bubble”.An exchange-rate bubble exists when holders of a currency realize that it is overvalued but they are nevertheless willing to hold it, since they believe that the appreciation will continue for a while longer and that there is only a limited risk of a serious depreciation during a given holding period.So speculators expect to be able to sell eventually at an exchange rate that will provide them with a sufficient capital gain to compensate them for running the risk of a sudden collapse.Such speculation both prolongs an exchange overvaluation and aggravates the macroeconomic costs associated with it.

Hence, there are a variety of arguments as to an argument for a fixed may be destabilizing, which is in turn used as an argument for a fixed rather than a floating exchange rate.However, we have to be extremely careful here because a fixed rate can be fixed at the wrong level, just as a floating rate can float to the wrong level.Even if a fixed rate is initially fixed at the optimal exchange rate, when the economic fundamentals change the fixed parity then becomes the wrong rate.