APPENDIX: Formal Description of the Model
Argy, Victor, and Michael G. Porter, “The Forward Exchange Market and the Effects of Domestic and Foreign Disturbances Under Alternative Exchange Rate Systems,” Staff Papers, International Monetary Fund (Washington), Vol. 19 (November 1972), pp. 503–28.
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Bhagwati, Jagdish N., “Fiscal Policies, the Faking of Foreign Trade Declarations, and the Balance of Payments,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 29 (February 1967), pp. 61–77.
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)| false “ Bhagwati, Jagdish N., Fiscal Policies, the Faking of Foreign Trade Declarations, and the Balance of Payments,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 29( February 1967), pp. 61– 77. 10.1111/j.1468-0084.1967.mp29001004.x
Bhagwati, Jagdish N., Foreign Trade Regimes and Economic Development: Anatomy and Consequences of Exchange Control Regimes (Cambridge, Massachusetts: Ballinger, 1978).
Blejer, Mario I., Exchange Restrictions and the Monetary Approach to the Exchange Rate,” in The Economics of Exchange Rates, ed. by Jacob A. Frenkel and Harry G. Johnson (London: Addison-Wesley, 1978), pp. 117–28.
Braga de Macedo, Jorge, “Exchange Rate Behavior with Currency Inconvertibility,” Journal of International Economics (Amsterdam), Vol. 12 (February 1982), pp. 65–81.
Cumby, Robert E., Monetary Policy Under Dual Exchange Rates” (unpublished, International Monetary Fund, May 17, 1983).
Dickie, Paul M., and David B. Noursi, “Dual Markets: The Case of the Syrian Arab Republic,” Staff Papers, International Monetary Fund (Washington), Vol. 22 (July 1975), pp. 456–68.
Dornbusch, Rudiger, and others, “The Black Market for Dollars in Brazil,” Quarterly Journal of Economics (Cambridge, Massachusetts), Vol. 98 (February 1983), pp. 25–40.
Fleming, J. Marcus, “Dual Exchange Markets and Other Remedies for Disruptive Capital Flows,” Staff Papers, International Monetary Fund (Washington), Vol. 21 (March 1974), pp. 1–27.
Flood, Robert P., “Exchange Rate Expectations in Dual Exchange Markets,” Journal of International Economics (Amsterdam), Vol. 8 (February 1978), pp. 65–77.
Flood, Robert P., and Nancy P. Marion, “The Transmission of Disturbances Under Alternative Exchange-Rate Regimes with Optimal Indexing,” Quarterly Journal of Economics (Cambridge, Massachusetts), Vol. 97 (February 1982), pp. 43–66.
Kami, Edi, “On the Specification of Asset Equilibrium in Macroeconomic Models: A Note,” Journal of Political Economy (Chicago), Vol. 87 (February 1979), pp. 171–77.
Krueger, Anne O., Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences (Cambridge, Massachusetts: Ballinger, 1978).
Lanyi, Anthony, “Separate Exchange Markets for Capital and Current Transactions,” Staff Papers, International Monetary Fund (Washington), Vol. 22 (November 1975), pp. 714–49.
Marion, Nancy P., “Insulation Properties of a Two-Tier Exchange Market in a Portfolio Balance Model,” Economica (London), Vol. 48 (February 1981), pp. 61–70.
Michaely, Michael, “A Geometrical Analysis of Black-Market Behavior,” American Economic Review (Nashville, Tennessee), Vol. 44 (September 1954), pp. 627–37.
Sargent, Thomas J., and Neil Wallace, “The Stability of Models of Money and Growth with Perfect Foresight,” Econometrica (Evanston, Illinois), Vol. 41 (November 1973), pp. 1043–48.
Sheikh, Munir A., “Black Market for Foreign Exchange, Capital Flows, and Smuggling,” Journal of Development Economics (Amsterdam), Vol. 3 (March 1976), pp. 9–26.
Swoboda, Alexander K., The Dual Exchange-Rate System and Monetary Independence,” in National Monetary Policies and the International Financial System, ed. by Robert Z. Aliber (Chicago: University of Chicago Press, 1974) , pp. 258–70.
Turnovsky, S.J., “Monetary Policy, Fiscal Policy and the Government Budget Constraint,” Australian Economic Papers (Adelaide), Vol. 14 (December 1975) , pp. 197–215.
Mr. Nowak, economist in the Exchange and Trade Relations Department, is a graduate of the University of Manchester and also studied at the University of Western Ontario.
Examples are the United Kingdom in 1947–79, Belgium since 1951, France in 1971–74, Italy in 1973–74, and the Rand Monetary Area in 1974–83.
For example, Krueger (1978, p. 55) has stated that “…exchange rate changes under QRs [quantitative restrictions] cannot be analyzed in exactly the same manner as would a devaluation undertaken from an initial position of currency convertibility.” See also Bhagwati (1978).
Dickie and Noursi (1975) estimated a model of the parallel foreign exchange market in Syria, but, while acknowledging the existence of formal controls, did not explicitly take them into account. A simple flow model of the parallel market has been developed by Bhagwati (1967), but attention in that study is restricted to an examination of the effects that illegal transactions have on the officially recorded and actual balance of payments. Dornbusch and others (1983) have constructed a portfolio-balance–currency-substitution model of the black market for foreign exchange in Brazil, but the partial equilibrium approach they adopted precludes an examination of the economywide impact of policy shifts in the presence of quantitative controls.
This conclusion is applicable not only to unified exchange rate models but also to dual market models in which the official foreign exchange market clears through movements in central bank reserves. For example, Argy and Porter (1972) and Swoboda (1974) use a pure-flow model, and Cumby (1983) employs a portfolio-balance framework to examine the implications of segregating current and capital transactions into fixed and floating rate markets. The short-run insulation properties of this type of dual system are dealt with in taxonomic fashion by Marion (1981). See also Fleming (1974), Flood (1977), Blejer (1978), and Flood and Marion (1981). With regard to the effectiveness of monetary policy under conditions of high capital mobility, this class of model generates results that in essence correspond to those of the basic model for a flexible-unified exchange rate in the short run and to those of the fixed rate model in the long run. The long-run effect of a devaluation in all these models is a once-and-for-all increase in reserves and an equiproportionate rise in all prices. Leakage between the two markets as a result of illegal transactions weakens, but does not qualitatively alter, the basic properties of the dual market model; see Lanyi (1975) and Braga de Macedo (1982).
This description corresponds to the fixed-unified exchange rate case and to the official market segment of a dual rate regime without import controls.
This may be recognized as a case of the Marshallian equivalence proposition. Bhagwati (1978) has argued that, in practice, this equivalence will break down because the two prices (in this example, e1 and
This subsection is in the spirit of a model by Michaely (1954), which presents a geometric exposition of the determination of black market prices. For an application of this model to black markets in foreign exchange, see Sheikh (1976). The presentation here is somewhat simpler than in these two papers because it avoids construction of an exceedingly complicated demand curve for the black market. It also allows the path of the black market exchange rate to be traced as it responds to changes in the official rate.
It is assumed throughout this subsection that the economy is on a given production possibility frontier, so that aggregate production, appropriately measured, is fixed. The assumptions underlying the curves drawn in Figure 2 are set out fully in the Appendix.
In this deterministic model, the (known) marginal cost of smuggling varies with distance from the frontier. For an elaboration of this relationship, see the Appendix.
The conclusions of this subsection, however, obviously are sensitive to the assumptions relating to the penalty costs of transacting in the parallel market. In this regard, the existence of smuggling costs is a crucial assumption underlying the negative slope of the unification path. In the absence of such costs, all producers would sell on the parallel market whenever the premium in this market was positive. Thus, the supply curve OA in Figure 2 would be flatter, passing through the point R. Without official reserve intervention, the unification path would, therefore, be a horizontal line passing through the points
The following is a national income accounting treatment of aggregate output. Measurement errors arise when relative prices in the current period differ from those in the base period. For small changes in relative prices over time, however, this error may be safely ignored.
All base-period prices (including the parallel exchange rate e) have been set equal to 1 (with the exception of the official exchange rate
Points on IS0 to the northeast of Z satisfy equation (1), with the condition that the partial derivative X1 and the function
The greater-than-unitary elasticity of IS below point Z reflects the fact that equal proportionate changes in pn and in e, but not in
Static expectations mean that the value expected in the next period is equal to the current (known) value; that is,
Because the analysis throughout assumes that there are no interest-bearing assets, increases in domestic credit that are not associated with the financing of government purchases of commodities arise out of “helicopter” operations or, equivalently, cash grants from the government to the private sector.
The indeterminate effect on the parallel rate in the impact period reflects the adoption of an end-of-period, asset-equilibrium specification. In a beginning-of-period formulation, asset supplies (including the stock of money) are held stationary in the impact period. Hence, an increase in government spending initially involves only a leftward shift of the IS curve and leads unambiguously to an appreciation of the parallel rate. As in the end-of-period formulation, however, money financing in subsequent periods results in a rightward shift of the LM curve and produces a progressive depreciation of the parallel rate. A discussion of the issues involved in the alternative specifications of asset market equilibrium is contained in Kami (1979). For an example of an end-of-period model that incorporates a government budget constraint, see Turnovsky (1975).
The analytical techniques used in this subsection are discussed in detail in Sargent and Wallace (1973).
The decline in
Net sales of foreign exchange by the central bank produce a leftward shift in the LM curve and are thus identical in their effect to a contraction in domestic credit.
The real wage level will tend to rise with a devaluation because, as discussed above, the price level will decline with the increase in output.