Tobin Tax and Market Depth

This paper investigates-on the basis of the Cont-Bouchaud model-whether a Tobin tax can stabilize foreign exchange markets. Compared to earlier studies, this paper explicitly recognizes that a transaction tax-induced reduction in market depth may increase the price responsiveness of a given order. We find that the imposition of a transaction tax may still achieve a triple dividend: (1) exchange rate fluctuations decrease, (2) currencies are less mispriced, and (3) central authorities raise substantial tax revenues. However, if the price impact function is too sensitive with respect to market depth, stabilization may turn into destabilization. 1 We thank Thomas Lux for bringing this group together and for his suggestion to take into account the feedback that reduced speculation via reduced market depth may increase exchange rate variability, and B. Rosenow for comments on the manuscript.