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Stabilizing Rational Speculation and Price Level Targeting

Author

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  • Reither, Franco

    (Helmut Schmidt University, Hamburg)

  • Bennöhr, Lars

    (Helmut Schmidt University, Hamburg)

Abstract

We analyze the contribution of speculation to exchange rate volatility using different assumptions regarding speculation strategies and monetary policy rules. We take the DORNBUSCH (1976) model as the starting point and adopt a slight modification of the money demand specification. With a money supply rule, rational speculation dampens the overshooting of the exchange rate following a money supply shock, compared with speculation based on static expectations. Then, we replace the LM condition by a TAYLORtype price level targeting rule rule. The resulting “DORNBUSCH-TAYLOR” model generates a unique saddle point solution even under ‘strict’ inflation targeting, if speculation is based on rational expectations. Under ‘flexible’ inflation targeting, exchange rate overshooting induced by a monetary policy shock is less pronounced under rational speculation than under static speculation. FOREX market equilibrium doesn’t exist at all if speculation is static and monetary policy adopts‘strict’ inflation targeting.

Suggested Citation

  • Reither, Franco & Bennöhr, Lars, 2010. "Stabilizing Rational Speculation and Price Level Targeting," Working Paper 104/2010, Helmut Schmidt University, Hamburg.
    • Handle: RePEc:ris:vhsuwp:2010_104
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    More about this item

    Keywords

    rational expectations; DORNBUSCH Model; open economy macroeconomics; speculation; FOREX;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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