Question

Discuss why exchange rates are volatile according to ‘speculative bubble approach’.

Answer 1

Basic understanding is essential to understand the whole concept of exchange rates & it's volatility according to ‘speculative bubble approach.

An exchange rate:- exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency.Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of a country whereas floating exchange rates are decided by the mechanism of market demand and supply.

Volatile:- Change rapidly and unpredictably, especially for the worse.

speculative bubble:- A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class that is fueled by speculation as opposed to fundamentals of that asset class. A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values.

Now, its time to enter into specific issue i.e. why exchange rates are volatile according to ‘speculative bubble approach'.

since a floating exchage rate system was introduced for the major world currencies in the spring of 1973, exchange rates have been quite volatile & create difficult problem to the management of monetary policy and economic policy in general.

Nowadays the phrase " the deviation of exchange rates from the economic fundamentals" has been widely heard. "Bubble" is one typical example of a theory which directly treats such kind of deviation. As explained previously, A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class that is fueled by speculation as opposed to fundamentals of that asset class.

A bubble arises in exchange rate because rational
investors keep shorting domestic currency even after learning that it is no longer
overvalued. Foreign currency becomes temporarily overvalued until the bubble bursts
and the currency returns to a level consistent with fundamental value. The possibility of
bubbles has two main implications for theories of balance-of-payments crises. First, self-
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fulfilling crises become more likely, since even if the absence of post-collapse
expansionary policy, the bubble causes the domestic currency to depreciate after the peg
is abandoned, at least temporarily. Second, the model provides a rationale for high
interest rates after the peg is abandoned, since high interest can reduce, or even eliminate,
overshooting due to bubbles.

Currency Derivative market will widely impact by speculative bubbles which lead to rapid raise or fall in exchange rate.

There have been various developments in exchange rate theory in the 1970's, centering around the asset approach to exchage rate determination which is instable. however more recently, speculative bubbles have been in the limelight which adversly affects the exchage rate & it's volatility.