Speculation, Profitability, and Stability
PROPONENTS of flexible exchange rates have maintained that a completely free exchange market is very likely to be stable. In particular they have argued that any profitable speculative activity in this and other markets must necessarily be stabilizing. By this they appear to mean that it must, ceteris paribus, reduce the frequency and amplitude of price fluctuations. In this note, I dispute this allegedly universal proposition with the aid of a counterexample. Certainly this counterexample is not meant to suggest that profitable (or even unprofitable) speculation will never exert a stabilizing influence. How often and to what extent speculation is stabilizing remains a matter for empirical inquiry. Perhaps a more important aim of this note is to indicate the sort of mathematical apparatus which is necessary for an analysis of the effects of speculation on stability. The techniques are precisely those which have been used in other stability analyses, and it is surprising that they do not seem to have been employed in this area. Because most of the mathematical analysis of speculation and stability has been conducted in static terms, it has failed to get to the heart of the stability question which, of course, refers to properties of the price movements.