Rational speculators and exchange rate volatility

This paper suggests a plausible microstructural connection between rational speculative activity and exchange rate volatility. When Friedman (Essays in Positive. Economics, University of Chicago Press, 1953) claimed that rational speculators must smooth exchange rates, he excluded interest rate differentials from his interpretation of speculator behavior. Informed, rational speculators who consider interest differentials will magnify the exchange rate effects of interest shocks and could increase overall exchange rate volatility. This connection between speculators and volatility, which does not rely on asymmetric information, is structural because speculators affect the exchange rate's generating process. Rational speculation is stabilizing at low levels of speculative activity and destabilizing at high levels. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: F31; G12.