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Optimal Exchange Rates: A Market Microstructure Approach

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  • Guembel, Alexander
  • Sussman, Oren

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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Paper provided by University of Toulouse 1 Capitole in its series Open Access publications from University of Toulouse 1 Capitole with number http://neeo.univ-tlse1.fr/2039/.

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Date of creation: Dec 2004
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Publication status: Published in Journal of the European Economic Association (2004-12) v.2, p.1242-1272
Handle: RePEc:ner:toulou:http://neeo.univ-tlse1.fr/2039/

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Web page: http://www.univ-tlse1.fr/

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  1. Dow, J. & Rahi, R., 1997. "Should Speculators be Taxed?," Economics Working Papers eco97/21, European University Institute.
  2. Jeffrey A. Frankel & Giampaolo Galli & Alberto Giovannini, 1996. "Introduction to "The Microstructure of Foreign Exchange Markets"," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 1-18 National Bureau of Economic Research, Inc.
  3. Killeen, William P. & Lyons, Richard K. & Moore, Michael J., 2006. "Fixed versus flexible: Lessons from EMS order flow," Journal of International Money and Finance, Elsevier, vol. 25(4), pages 551-579, June.
  4. Vitale, Paolo, 1999. "Sterilised central bank intervention in the foreign exchange market," Journal of International Economics, Elsevier, vol. 49(2), pages 245-267, December.
  5. Ronald McKinnon & Gunther Schnabl, 2004. "The East Asian Dollar Standard, Fear of Floating, and Original Sin," Review of Development Economics, Wiley Blackwell, vol. 8(3), pages 331-360, 08.
  6. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
  7. Vitale, Paolo, 2003. "Foreign exchange intervention: how to signal policy objectives and stabilise the economy," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 841-870, May.
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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. 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.
  3. Markus Haberer, 2003. "Some Criticism of the Tobin Tax," CoFE Discussion Paper 03-01, Center of Finance and Econometrics, University of Konstanz.
  4. Alexander Gümbel, 2005. "Should short-term speculators be taxed, or subsidised?," Annals of Finance, Springer, vol. 1(3), pages 327-348, 08.

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