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Pierre-Richard Agénor is an Economist in the Developing Country Studies Division of the Research Department.
Robert P. Flood is a Senior Economist in the Capital Markets and Financial Studies Division of the Research Department. He holds graduate degrees from the University of Rochester.
The authors would like to thank Saul Lizondo and Malcolm Knight for helpful discussions and comments.
Although, in theory unification could also take the form of the adoption of a uniform fixed rate or crawling peg regime—with changes in net foreign assets clearing the official foreign exchange market—few developing countries have adopted this approach in recent years.
Pinto’s analysis assumes that agents are subject to rationing in the officiai market for foreign exchange. Lizondo (1991) has shown, however, that Pinto’s emphasis on the trade-off between the premium and inflation in the unification process remains largely valid if the official market clears through changes in foreign reserves. The existence of a trade-off, nevertheless, hinges crucially on the assumption of a positive premium in the steady state. However, most models of dual exchange rate markets with leakages—such as Bhandari and Végh (1990), Gros (1988), as well as the one presented here—predict a zero premium in the steady state.
Pinto (1991a) focused on the inflationary impact of exchange rate unification, and Lizondo (1987) and Kiguel and Lizondo (1990) examined only exchange rate and balance of payments effects. In both analyses, output is taken as fixed at its full-employment level.
The analysis in Section II dwells, in part, on Flood and Marion (1983), who developed a model of exchange rate regimes in transition, based on the Italian two-tier foreign exchange market in 1973–74. Issues similar to those considered here were also examined by Calvo (1989), Djajic (1989), and Obstfeld and Stockman (1985).
In Ghana, for instance, unification took the form of large, but widely spaced, devaluations over almost four years (April 1983–March 1987)—with an overnight float occurring at the last stage—and was accompanied by reductions in the fiscal deficit. By contrast, in Nigeria the currency was floated overnight in September 1986.
This was the case, most notably, in Nigeria.
Peru’s attempt in August 1990 to unify its foreign exchange markets by floating its exchange rate is also consistent with this pattern. The parallel market premium, which stood at close to 200 percent at the end of 1989, rose to more than 400 percent a month before the reform—which was widely anticipated—-was implemented. The premium fell immediately afterwards as a result of a large depreciation of the official exchange rate, and dropped below 20 percent by December 1990.
The coefficient v can be viewed alternatively as an approximation to the share of transactions settled illegally in the parallel market relative to total trade transactions.
Note that, although interest receipts are assumed to be repatriated at the official exchange rate, they are not accounted for in equation (5) for simplicity.
The saddlepath SS is also flatter than ˙st = 0. An increase in the interest elasticity, α, rotates the curves ṡt, = 0 and SS clockwise. An increase in shifts the curve ṡt, = 0 to the left and moves point E horizontally to the left. A rise in the propensity to underinvoice, Φ, translates into a clockwise rotation of the saddlepath SS. Finally, a devaluation of the official exchange rate leads to an upward shift of the Ṙ, = 0 curve and a right ward (leftward) shift of the ṡt, = 0 curve, if 1—v is greater (lower) than αγ. Nevertheless, a devaluation always leads to an equiproportional depreciation of the parallel exchange rate and an increase in reserves in the steady state (equation (8c)).
The price continuity principle, which can be justified as a condition to eliminate speculative profits at the time of transition, has been used extensively in the literature on speculative attacks (see Agenor, Bhandari, and Flood (1992)). However, note that in the present framework agents do not have a direct—and costless—access to official reserves. Here, capital account transactions through the official foreign exchange market are prohibited, and agents can only deplete official reserves by illegally diverting export remittances to the parallel market—presumably at a fixed (albeit nonprohibitive) cost. Consequently, speculative attacks on official reserves cannot occur.
For a depreciation to occur, in addition to the condition
In this case, the parallel exchange rate always appreciates after the announcement, since, by assumption,
Unification before the dual-rate regime reaches its steady state reduces reserve losses due to leakages; equation (14b) shows that since
Regardless of the path followed in the dual-rate regime, the economy must reach point E′ at time T. Note that point E′ is necessarily located northeast of point E, since
The condition under which the parallel exchange rate will jump to a point such as D is given by using equation (14a) and the equation of the saddlepath given above:
Setting T→∞ in equations (13a) and (13b) indicates that T→G/κ1 and B→>0, so that the solutions for st, and Rt, coincide with those for ̃st, and ̃Rt. Similarly, setting T→ 0 in equations (14a) and (14b) yields
As before, all coefficients are defined as positive in what follows.
Formally, these conditions are c2→0, and v ≤1/c2.
The path of reserves and the parallel exchange rate is qualitatively similar to what is shown in Figure 2 and is therefore omitted for simplicity. The real exchange rate in what follows is assumed to be measured as the difference between the parallel rate and the price level—that is, by setting σ = 1.
Note that this result does not depend on whether the real exchange rate is measured in the standard way by using the official exchange rate (σ—0) or by using the parallel exchange rate (σ = 1). In fact, in the former case the real exchange rate appreciation is more pronounced than in the general case.
If, in equation (18), the price level was assumed to depend also on the official exchange rate, prices would experience a jump at r = T as a result of the depreciation occurring in the official market.
A formal proof of this proposition can be derived by extending the procedure developed in Flood and Marion (1983).
See Kragman (1991). Following Flood and Marion (1983), Froot and Obstfeld (1991) examined the unification issue in the context of a stochastic dual-rate model in which both exchange rates are floating. However, analytical solutions for systems with two state variables of the type considered here are not so far available.