Optimal Exchange Rates: A Market Microstructure Approach

Alexander Guembel () and Oren Sussman
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Oren Sussman: Wadham College and Saïd Business School, University of Oxford,

Journal of the European Economic Association, 2004, vol. 2, issue 6, 1242-1274

Abstract: Motivated by the observation that exchange-rate management resembles market-making, we use microstructure theory to conduct a welfare analysis of exchange-rate management, includ-ing 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. (JEL: E58, F31, G14, O24) Copyright (c) 2004 by the European Economic Association.

Date: 2004
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