Short-term speculators and the puzzling behaviour of exchange rates

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Abstract This paper shows that rational short-term speculative activity transforms exchange rates' response to shocks. Transitory shocks will have a permanent impact on exchange rates when such speculators are active, and the impact of shocks will be smoothed. The model may help explain the observed extended response of exchange rates to sterilized intervention. Further, the model suggests that exchange rate fundamentals may be properly identified even when those variables fail to forecast better than a random walk. Finally, the model could help explain why exchange rates closely resemble a random walk while most fundamentals do not follow such a process.