Mr. Day, economist in the Financial Studies Division of the Research Department when this paper was prepared, is currently in the Central European Division of the European Department. He is an external graduate of the University of London and received his doctorate from the University of Birmingham. Before joining the Fund, he taught at the University of Manchester.
J. Marcus Fleming, “Dual Exchange Rates for Current and Capital Transactions: A Theoretical Examination,” Ch. 12 in his book, Essays in International Economics (Harvard University Press, 1971), pp. 296–325; “Dual Exchange Markets and Other Remedies for Disruptive Capital Flows,” Staff Papers, Vol. 21 (March 1974), pp. 1–27. See also Vittorio Barattieri and Giorgio Ragazzi, “An Analysis of the Two-Tier Foreign Exchange Market,” Banca Nazionale del Lavoro, Quarterly Review (December 1971), pp. 354-72; B. Decaluwe, “Two-Tier Exchange Markets and Other Systems: A Comparison,” Tijdschrift voor Economie, Vol. 19 (1974), pp. 55-79; and Anthony Lanyi, “Separate Exchange Markets for Capital and Current Transactions,” Staff Papers, Vol. 22 (November 1975), pp. 714–49.
William H. L. Day, “The Advantages of Exclusive Forward Exchange Rate Support,” Staff Papers, Vol. 23 (March 1976), pp. 137–63; see also “Domestic Interest Rates Under a Pegged Forward Exchange Rate” (unpublished, International Monetary Fund, June 10, 1975).
If the target of official intervention in the financial market were immunity of the reserves—defined in the literature as “neutral intervention policy”—it could be shown that: (1) an uncovered capital inflow would be induced equal to the sum of the trade deficit and the official loss on exchange transactions; (2) the money supply would increase by the magnitude of the official loss; and (3) both the reserves and the official open foreign currency position would be fully insulated.
For a formal presentation, see Lanyi, op. ext., Appendix I, pp. 739–40.
The actual ΔOFCG is greater (less) than the approximation given in equation (30) by the extent to which the trade balance on day T + t times Xt, T is greater (less) than the current trade balance times Xt, T-t.
Although an uncovered capital inflow could decrease the total risk on an individual’s portfolio owing to negative covariance, the total risk on the portfolio must begin to increase eventually as more of the portfolio is invested in the currency on an uncovered basis. In the limit when all of the portfolio is invested in the currency on an uncovered basis, negative covariance cannot be present.
Under normal dual exchange market regulations, traders are free to accumulate commercial balances transferable at the official spot rate.
This assumes that banks act only as brokers in the forward commercial market, marrying supply and demand by traders and not themselves carrying an open forward position. However, preventing banks from providing a linkage between the financial and commercial markets requires only that changes in the combined open position of banks spot and forward on commercial accounts be offset by spot operations with the central bank at the official rate. Allowing banks to hold open forward positions on commercial accounts while requiring them to be offset by spot operations in the commercial market means that, although traders in aggregate will be able to alter their exposure to exchange risk by operations in the commercial forward market, such changes will be transmitted by banks to the spot market and will be equivalent to a change in timing of spot foreign exchange contracts by traders.
For a description of trader arbitrage and its dependence on the covered interest rate differential, see John Spraos, “Speculation, Arbitrage and Sterling,” Economic Journal, Vol. 69 (March 1959), pp. 1–21.
For a discussion of the difficulties involved in separating exchange markets and the types of link that can arise between the markets, see Lanyi, op. cit., pp. 719–22.
This has assumed that profits from evasion are taken in foreign currency. To the extent that they are taken in domestic currency, however, the financial rate will appreciate. These results hold whenever the authorities maintain a constant change in the money supply owing to the balance of payments, be it zero or nonzero. When profits from evasion are taken in domestic currency rather than foreign currency, official action will offset the impact on the spread if a constant change in the level of reserves is maintained by official operations in the financial market.
Again, this has assumed that profits are taken in foreign currency. If profits are taken in domestic currency, the spot rate will tend to appreciate.
See, for example, “An International Banking Survey,” Economist, Supplement, January 27, 1973, p. 17.