Speculation In The Flexible Exchange Revisited

This article analyzes the exchange speculation in the French franc when the exchange rate was floating in the 1920's to determine both whether speculation was stabilizing or destabilizing, the relationships between speculation and domestic inflation. Speculative behavior is analyzed by comparing changes in the spot rate with changes in the forward rate (adjusted for changes in the money market‐interest differential). The impact of speculation on the price level is analyzed by measuring the terms‐of‐trade effect, the decrease in export prices necessary to generate increased net exports, and the absorption effect, the increase in the current account balance necessary to finance the capital outflow. The comparison of changes in the spot rate and forward exchange rate lead to the conclusion that speculation was destabilizing during much of the 1924‐26 period. Only a relative small part of the observed price increases during this period appeared as a result of the terms‐of‐trade and the absorption effects. However, during the period when speculation was destabilizing, the economy was becoming less liquid; the demand for money was falling. This reduction is attributed to a reaction to speculation against the franc. Both the reduction in demand for money and the speculation against the franc could be attributed to some other factors, especially to political instability. Since the exchange rate depreciated much more rapidly than domestic prices increased, it is concluded that speculation was a trigger rather than a response.