Optimal Exchange Rates: A Market Microstructure Approach

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.