Abstract
This paper scrutinizes the claim by Eichengreen, Tobin and Wyplosz (1995) that a small tax on foreign exchange transactions would help to stabilize the European Monetary System. We present a target zone model a la Svensson (1994) in which an optimizing government is faced with a trade-off between its foreign exchange and its domestic objectives. The introduction of a Tobin tax is shown to improve the credibility of the peg by relaxing the foreign exchange rate constraint and making it less costly for the government to stay in the fixed exchange rate system. We calibrate the model using data on the French franc in 1991-93, and show that the stabilizing effect of a 0.1% Tobin tax would have been quite sizeable. Copyright 1996 by The editors of the Scandinavian Journal of Economics.
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