Optimal exchange rates: a market microstructure approach

Guembel, Alexander and Sussman, Oren (2004) Optimal exchange rates: a market microstructure approach. European Economic Association. Journal, 2 (6). pp. 1242-1274.


Motivated by the observation that exchange-rate management resembles market-making, we use microstructure theory 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 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.

Item Type: Article
Keywords: Exchange rates; Central bank policy; Market microstructure; Incomplete markets; Tobin tax; finance
Subject(s): Finance
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Date Deposited: 18 Feb 2012 20:57
Last Modified: 27 Feb 2017 10:23
Funders: N/A
URI: http://eureka.sbs.ox.ac.uk/id/eprint/2943

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