In Defense of a Tax on Foreign Exchange

By Prasch, Robert E. | Journal of Economic Issues, June 1998 | Go to article overview
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In Defense of a Tax on Foreign Exchange


Prasch, Robert E., Journal of Economic Issues


This past fall has been a most interesting period in the history of the world's financial markets. Several East Asian countries, so recently celebrated as models of orthodox economic development strategies, suddenly foundered under the pressure of dramatic capital outflows. Following a time-honored script, the "cure" was to impose draconian austerity programs on these countries along with a good deal of unsolicited advice on "economic fundamentals."

The general principle that underlies this response is a presumption that foreign exchange is a commodity not intrinsically different from the proverbial "widgets" of the principles books. Once it is supposed that the foreign exchange (FX) market is orderly and self-regulating, there is no compelling reason for any government or international agency to employ its resources toward the maintenance of any particular value of any particular currency [Friedman 1953]. This line of reasoning can be questioned. A closer look suggests that laissez faire may not be the best policy option for the world's FX markets.

Unique Characteristics of Foreign Exchange Markets

The logic that drives the standard theory of the market process, and what renders it so powerful, is that there is no single force operating simultaneously on both sides of the market. Specifically, there are no problems of asymmetric information, no "bandwagon" effects, and the degree of preference is independent of the market price. Nevertheless, a number of actual existent markets cannot be described in this manner [Leibenstein 1950; Prasch 1992; Stiglitz 1987]. The FX market is an important instance in which a number of factors operate simultaneously on both the supply and demand sides of the market. This reality inhibits the formation of a uniquely determined equilibrium in the market for foreign exchange.

Let us consider the market for German marks. In this market, the demand curve represents the number of marks that are desired over a given period of time, at a given price, as expressed in dollars. The overall demand for marks, which is to say the position of the demand curve, is determined by such factors as:

1. Expected changes in the $/DM exchange rate.

2. Changes in the incomes of American residents.

3. Changes in the relative level of prices between the two countries.

4. Changes in the relative expected returns on assets between the two countries.

5. Changes in the preference for German-made goods by those who currently hold American dollars - typically American consumers.

The supply curve represents the potential supply of German marks that will be offered by the holders of marks for a particular price (in US $) over a given period of lime. As is the case with demand, the supply curve is subject to changing market conditions. Forces that induce such shifts are of the following nature:

1. Expected changes in the exchange rate.

2. Changes in the incomes of German residents.

3. Changes in the relative price level between the two countries.

4. Changes in the relative expected returns on assets between the two countries.

5. Changes in the preference for American-made goods by holders of German marks - typically German residents.

From the above, we can see that in the market for foreign exchange, the only independent forces at work are domestic incomes and consumer preferences within each country. Every other cause operates simultaneously on both the supply and demand for foreign exchange. This implies that a single causal event can result in both curves adjusting at the same time. Moreover, the presence of price expectations on both sides indicates that a shift in either schedule can be expected to induce a further shift in both schedules. Moreover, it is reasonable to suppose that the value of foreign exchange depends on the current and anticipated value of that asset. In such cases, "animal spirits" and herd behavior become important aspects of the market [Davidson 1997; Keynes 1964, chap.

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