Rational Speculative Bubbles in an Exchange Rate Target Zone

The recent theory of exchange rate dynamics within a target zone holds that exchange rates under a currency band 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 <MI>a priori<D> that excess volatility due to rational bubbles does not occur in the foreign exchange market. In this paper we consider instead a set-up in which the existence of speculative behaviour is a datum with which the central bank has to deal. We show that the defence 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. We show that the instantaneous volatility of exchange rates within a bank is not necessarily less than the volatility under free float. There need not be a constant tradeoff between the volatility of the change in the exchange rate and the volatility of the change in the interest rate differential. Fundamental-dependent bubbles can account for the excess response of the exchange rate to the fundamental. The relationship between the exchange rate and the interest differential need not be negative, even if the target zone is fully credible.