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Optimal Exchange Rates: A Market Microstructure Approach

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Author Info

  • Alexander Guembel

    (Lincoln College and Saïd Business School, University of Oxford,)

  • Oren Sussman

    (Wadham College and Saïd Business School, University of Oxford,)

Abstract

Motivated by the observation that exchange-rate management resembles market-making, we use microstructure theory to conduct a welfare analysis of exchange-rate management, includ-ing the "corner solutions" of a free float and a fixed peg. We show that a policy that smoothes out exchange-rate fluctuations needs to trade off the welfare gain due to lower risk exposure of local producers against the trading losses that the policy would generate due to speculation. We identify the conditions under which exchange-rate management can increase welfare and argue that these conditions are more likely to be satisfied in illiquid markets, mainly small economies and emerging markets. We also explore the role of a Tobin tax (assuming enforceability) in facilitating exchange-rate management. (JEL: E58, F31, G14, O24) Copyright (c) 2004 by the European Economic Association.

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Bibliographic Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 2 (2004)
Issue (Month): 6 (December)
Pages: 1242-1274

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Handle: RePEc:tpr:jeurec:v:2:y:2004:i:6:p:1242-1274

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Cited by:
  1. William P. Killeen & Richard K. Lyons & Michael J. Moore, 2001. "Fixed versus Flexible: Lessons from EMS Order Flow," NBER Working Papers 8491, National Bureau of Economic Research, Inc.
  2. Alexander Gümbel, 2005. "Should short-term speculators be taxed, or subsidised?," Annals of Finance, Springer, vol. 1(3), pages 327-348, 08.
  3. Cukierman, Alex & Goldstein, Itay & Spiegel, Yossi, 2003. "The Choice of Exchange Rate Regime and Speculative Attacks," CEPR Discussion Papers 3714, C.E.P.R. Discussion Papers.
  4. Rose, Andrew K, 2010. "Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky," CEPR Discussion Papers 7987, C.E.P.R. Discussion Papers.
  5. Andrew K. Rose, 2011. "Exchange Rate Regimes in the Modern Era : Fixed, Floating, and Flaky," Journal of Economic Literature, American Economic Association, vol. 49(3), pages 652-72, September.
  6. Markus Haberer, 2003. "Some Criticism of the Tobin Tax," CoFE Discussion Paper 03-01, Center of Finance and Econometrics, University of Konstanz.

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