Optimal Exchange Rates: A Market Microstructure Approach

Journal of the European Economic Association, Vol. 2, No. 6, pp. 1242-1274, 2004

43 Pages Posted: 16 Jul 2001 Last revised: 28 Mar 2010

See all articles by Alexander Guembel

Alexander Guembel

Toulouse School of Economics, University of Toulouse Capitole

Oren Sussman

European Corporate Governance Institute (ECGI)

Date Written: July 13, 2004

Abstract

Motivated by the observation that exchange-rate management resembles market making, we use microstructure theory in order to conduct a welfare analysis of exchange-rate management, including 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 owing 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.

Keywords: exchange rates, central bank policy, market microstructure, incomplete markets, Tobin tax

JEL Classification: D82, E44, E58, F31, G14

Suggested Citation

Guembel, Alexander and Sussman, Oren, Optimal Exchange Rates: A Market Microstructure Approach (July 13, 2004). Journal of the European Economic Association, Vol. 2, No. 6, pp. 1242-1274, 2004, Available at SSRN: https://ssrn.com/abstract=276629 or http://dx.doi.org/10.2139/ssrn.276629

Alexander Guembel (Contact Author)

Toulouse School of Economics, University of Toulouse Capitole ( email )

Manufacture des Tabacs
21, allee de Brienne
Toulouse, 31000
France

Oren Sussman

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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