Financial and Real Investments: Some Notes on Tobin Tax

There is a consensus on the demerits of volatility in short-term capital flows, which is presumably prompted by exchange rate instability. The literature lists three methods to modulate financial markets: target zone of exchange rate, dual exchange rate, and the Tobin tax. This paper argues that the rationale for Tobin tax arises from two sources: systemic, and transitory. The interest rate parity theorem links up inflation, interest rate, and the exchange rate. Hence a general equilibrium approach is warranted here. Under uncertainty, irreversible real investment has an option-value for waiting. This is a distortion caused partly by exchange rate volatility; it can be reduced by a Tobin tax. If the Tobin tax on financial investment cannot fully eliminate the distortion, a subsidy for real investment to the extent of the said option-value may be worthwhile. In this paper a model shows that a financial boom can engender a recession in output. Another model computes the option-value of postponing real investment, where interest rate has a mean-reverting geometric Brownian motion. A third model explores macroeconomic instability, and an appropriate Tobin tax. The paper emphasizes the need for stabilization of both exchange rate and interest rate.