The Effect of a Transaction Tax on Exchange Rate Volatility

25 Pages Posted: 3 Oct 2007  

Markku Lanne

University of Helsinki - Department of Political and Economic Studies

Timo Vesala

University of Helsinki - Department of Political and Economic Studies

Date Written: 2006

Abstract

We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange markets. Our argument stems from the decentralised trading practice and the presumable discrepancy between 'informed' and 'uninformed' traders' valuations. Since informed traders' valuations are likely to be less dispersed, a transaction tax penalises informed trades disproportionately, leading to increased volatility. Empirical support for this prediction is found by investigating the effect of transaction costs on the volatility of DEM/USD and JPY/USD returns. High-frequency data are used and an increase in transaction costs is found to have a significant positive effect on volatility.

Keywords: transaction tax, exchange rates, volatility

JEL Classification: F31, F42, G15, G28

Suggested Citation

Lanne, Markku and Vesala, Timo, The Effect of a Transaction Tax on Exchange Rate Volatility (2006). Bank of Finland Research Discussion Paper No. 11/2006. Available at SSRN: https://ssrn.com/abstract=1018363 or http://dx.doi.org/10.2139/ssrn.1018363

Markku Lanne (Contact Author)

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland
+358-9-191 24626 (Phone)
+358-9-191 24780 (Fax)

Timo Vesala

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland

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