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How Well Do Foreign Exchange Markets Function: Might a Tobin Tax Help?

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  • Jeffrey Frankel.

Abstract

The case in favor of the Tobin tax features two major arguments. (1) Such a levy might reduce exchange rate volatility. A simple model giving this conclusion is presented in the Appendix. The starting point is a calculation showing that even a small tax would be a large disincentive to short-term transactions. The disincentive to long-term capital flows would be much smaller. This property does not extend to other forms of capital controls, and constitutes the beauty of the Tobin tax proposal. The crucial proposition then becomes that short-term speculation is on average destabilizing. Some support for this claim is cited, in the form of tests on survey data of exchange rate forecasts by market participants. (2) The Tobin tax would raise a lot of revenue more efficiently than alternative taxes such as tariffs. Some possible flaws in earlier estimates of revenue are pointed out here. The relevant base of transactions on which the tax would fall is larger than some have assumed, but the possible drop in trading volume in response to the tax is larger as well. A tax large enough to alter the structure of trading could conceivably collapse trading volume to as little as $151 billion/day. The author does not support a tax of this magnitude. Nevertheless, it is clear that even a more reasonable tax rate of 0.1 per cent would raise a lot of revenue, $166 billion per year in one estimate that is presented for the sake of concreteness. Whether this would be desirable depends heavily on the use to which the funds were put, or the alternative sources of tax revenue for which they are substituted.

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Bibliographic Info

Paper provided by University of California at Berkeley in its series Center for International and Development Economics Research (CIDER) Working Papers with number C95-058.

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Date of creation: 01 Nov 1995
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Handle: RePEc:ucb:calbcd:c95-058

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References

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  1. Jeffrey A. Frankel, 1994. "The Internationalization of Equity Markets," NBER Books, National Bureau of Economic Research, Inc, number fran94-1, May.
  2. Martin Eichenbaum & Charles Evans, 1992. "Some empirical evidence on the effects of monetary policy shocks on exchange rates," Working Paper Series, Macroeconomic Issues 92-32, Federal Reserve Bank of Chicago.
  3. Glosten, Lawrence R, 1994. " Is the Electronic Open Limit Order Book Inevitable?," Journal of Finance, American Finance Association, vol. 49(4), pages 1127-61, September.
  4. Culter, D.M. & Poterba, J.M. & Summers, L.H., 1990. "Speculative Dynamics," Working papers 544, Massachusetts Institute of Technology (MIT), Department of Economics.
  5. Dornbusch, Rudiger & Frankel, Jeffrey, 1988. "The Flexible Exchange Rate System: Experience and Alternatives," Department of Economics, Working Paper Series qt5ct1w459, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  6. Ito Takatoshi, 1994. "Short-Run and Long-Run Expectations of the Yen/Dollar Exchange Rate," Journal of the Japanese and International Economies, Elsevier, vol. 8(2), pages 119-143, June.
  7. De Grauwe, Paul & Dewachter, Hans, 1990. "A Chaotic Monetary Model of the Exchange Rate," CEPR Discussion Papers 466, C.E.P.R. Discussion Papers.
  8. Madhavan, Ananth, 1992. " Trading Mechanisms in Securities Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 607-41, June.
  9. Krugman, Paul & Miller, Marcus, 1992. "Why Have a Target Zone?," CEPR Discussion Papers 718, C.E.P.R. Discussion Papers.
  10. Jeffrey A. Frankel and Andrew K. Rose., 1995. "A Survey of Empirical Research on Nominal Exchange Rates," Center for International and Development Economics Research (CIDER) Working Papers C95-051, University of California at Berkeley.
  11. Kenneth A. Froot & Takatoshi Ito, 1988. "On the Consistency of Short-run and Long-run Exchange Rate Expectations," NBER Working Papers 2577, National Bureau of Economic Research, Inc.
  12. Jeffrey A. Frankel & Kenneth A. Froot, 1987. "Short-term and Long-Term Expectations of the Yen/Dollar Exchange Rate: Evidence from Survey Data," NBER Working Papers 2216, National Bureau of Economic Research, Inc.
  13. John Y. Campbell & Richard H. Clarida, 1987. "The Dollar and Real Interest Rates," NBER Working Papers 2151, National Bureau of Economic Research, Inc.
  14. 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.
  15. Flood, R.P. & Rose, A.K., 1992. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," Papers 529, Stockholm - International Economic Studies.
  16. Jeffrey A. Frankel & Shang-Jin Wei, 1998. "Regionalization of World Trade and Currencies: Economics and Politics," NBER Chapters, in: The Regionalization of the World Economy, pages 189-226 National Bureau of Economic Research, Inc.
  17. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
  18. Jeffrey A. Frankel, 1998. "The Regionalization of the World Economy," NBER Books, National Bureau of Economic Research, Inc, number fran98-1, May.
  19. Craig S. Hakkio, 1994. "Should we throw sand in the gears of financial markets?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 17-30.
  20. Janet Gale Stotsky & Parthasrathi Shome, 1995. "Financial Transactions Taxes," IMF Working Papers 95/77, International Monetary Fund.
  21. James Tobin, 1978. "A Proposal for International Monetary Reform," Eastern Economic Journal, Eastern Economic Association, vol. 4(3-4), pages 153-159, Jul/Oct.
  22. Jeffrey A. Frankel & Giampaolo Galli & Alberto Giovannini, 1996. "The Microstructure of Foreign Exchange Markets," NBER Books, National Bureau of Economic Research, Inc, number fran96-1, May.
  23. Morris Goldstein, 1995. "Exchange Rate System and the IMF: A Modest Agenda, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number pa39, July.
  24. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March.
  25. Fieleke, Norman S, 1981. "Foreign-Currency Positioning by U.S. Firms: Some New Evidence," The Review of Economics and Statistics, MIT Press, vol. 63(1), pages 35-42, February.
  26. Eichengreen, Barry & Tobin, James & Wyplosz, Charles, 1995. "Two Cases for Sand in the Wheels of International Finance," Economic Journal, Royal Economic Society, vol. 105(428), pages 162-72, January.
  27. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  28. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
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