Tobin tax and market depth

TL;DR

This paper uses the Cont-Bouchaud model to analyze how a Tobin tax affects foreign exchange market stability, revealing potential benefits and risks depending on market depth sensitivity.

Contribution

It explicitly considers how transaction tax-induced market depth reduction influences price responsiveness, providing new insights into stabilization versus destabilization effects.

Findings

Tobin tax can reduce exchange rate fluctuations

It can decrease currency mispricing

It generates substantial tax revenues for authorities

Abstract

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.