Dual exchange rate systems

Brenton, A.R. (1987). Dual exchange rate systems. MPhil thesis The Open University.

DOI: https://doi.org/10.21954/ou.ro.0000f7e4

Abstract

This thesis is in two chapters. The first surveys the existing literature on 'dual exchange rate systems' — where current and capital transactions are channeled through seperate foreign exchange markets. The early, comparative static, models concentrate on whether the instruments of demand management will work, and conclude that under dual regimes, unlike with fixed or floating unified rates, both fiscal and monetary policy can he effective. Later, dynamic, models focus on the impact of exogenous capital flows (usually represented by external interest rate movements) on economies with dual systems. The process of expectations formation proves crucial - so rational expectations appear naturally in a crop of papers whose shared conclusion is that a dual system entirely insulates the domestic economy from the effects of such flows. Finally, there have been studies of dual systems in practice. Their chief conclusion is that the benefits have been more questionable than theory would suggest.

The rational expectations model of a dual exchange market described in Chapter II goes beyond previous models in a number of ways. It permits precise comparison of the insulation properties of dual rates with those of other regimes. It allows for Government intervention between the two exchange markets under a dual regime. And it analyses the case where only imperfect information is available on the movements of external variables. The chief results are that for an open economy producing a differentiated product a dual system is likely to be more effective than either fixed or floating rates in insulating domestic activity from external interest rate movements (although perfect insulation is not achieved), and no less effective in insulating it from external price changes. This remains true when only imperfect information is available and also (although diminishingly so) when the Government intervenes between the exchange markets for capital and current transactions.