Informed Speculation and the Choice of Exchange Rate Regime

This paper explores the classic question regarding the costs and bene ̄ts of limiting exchange rate volatility starting from the premise that asset markets play an important role in aggregating information. I ̄nd that government trading, despite being completely observed, alters the ability of an asset market to reveal information. The main insight of the paper is that managing the exchange rate reduces the correlation and informational content of the exchange rate regarding persistent fundamentals and increases the correlation with short-run shocks. The result arises from the impact of government intervention on private speculation. Currency speculators have an incentive to di®erentiate shocks based on capital gains potential (which is related to persistence) and speculative trading therefore determines how exogenous shocks are re°ected in the equilibrium exchange rate. By smoothing the exchange rate, the government reduces the speculative incentive to separate shocks. The net result of government intervention is an exchange rate with lower total variance, but a larger percentage of high frequency volatility. In terms of quantities, movements in government reserves also become less informative as intervention is increased. ¤I would like to thank Daron Acemoglu, Olivier Blanchard, Ricardo Caballero, Rudiger Dornbusch, Jon Faust, Roberto Rigobon, Jaume Ventura, Alwyn Young, and participants at several seminars for many helpful comments and suggestions. All errors are mine. Email: [email protected]. 1101 E 58th Street, Chicago, IL 60637.