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 bard 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 a priori that excess volatility due to rational bubbles does not occur in the foreign exchange market. In this paper we consider instead a setup in which the existence of speculative behavior is a datum the Central Bank has to deal with. We show that the defense 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. These results hold for a large class of exogenous and fundamental-dependent bubble processes. We show that the instantaneous volatility of exchange rates within a bard is not necessarily less than the volatility under free float and analyze the implications for interest rate differential dynamics.