Optimal exchange-rates: a market-microstructure approach
We analyze exchange-rate management by the central bank when it makes the FX market for the sake of social-welfare objectives. It is assumed that markets are incomplete, so that agents are exposed to exchange-rate volatility against which they cannot fully hedge. It follows that the central bank may provide insurance by smoothing the exchange rate. However, smoothing the exchange rate also creates arbitrage opportunities for spec-ulators. We show that the central bank cannot smooth the exchange rate and deter speculation at the same time. A Tobin tax may provide a way out.