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Economics 426 Dual Exchange Rates the Varieties of Exchange Rate

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Economics 426 Dual Exchange Rates the Varieties of Exchange Rate Economics 426 Dual Exchange Rates The varieties of exchange rate regime are highlighted by Feenstra and Taylor in their figure 2.4. This note expands on one regime that you might be interested in knowing a bit more about: a dual exchange rate system. Under a dual exchange rate system there is a fixed rate and a floating rate and they apply to different transactions. Typically the fixed rate applies to certain current-account transactions and particularly to the purchase of important imports. The floating rate applies to capital-account transactions such as the sale of domestic assets. The two rates reflect conflicting motives of the monetary authorities. They want (a) affordable imports and (b) seigniorage (loose monetary policy). As they begin their mon- etary expansion the currency begins to depreciate. That makes imports more expensive in domestic currency. So instituting a fixed rate for certain key transactions can be one response. It is difficult to keep the two types of transactions segmented. Sometimes firms will try to represent any purchase of USD (the foreign currency) as an import of goods, so as to take advantage of the favorable exchange rate. With ongoing monetary expansion the currency will depreciate at the floating rate so, as you can imagine, it may be difficult to find someone who is happy to supply USD to importers at the official rate. In these circumstances the authorities sometimes will ban transactions at the floating rate entirely and it may become an unofficial or underground exchange rate. Sometimes the depreciation of the currency at the unofficial, floating rate will predict periodic devaluations at the fixed rate. That catch-up prevents the gap from widening indefinitely. The best example of this system operating near us is the Venezuelan bolivar (VEF). If you look up the wikipedia page on this currency you will see a time-series plot of the official/fixed rate and the unofficial/floating rate. It is illegal to display or advertise the unofficial rate within Venezuela. As just noted, the ongoing depreciation of the unofficial bolivar is followed by periodic devaluations of the official one. Cuba also operates with an unusual monetary system, but it has a dual currency rather than a dual exchange rate. Most people are paid in and use the national peso (CUP), which has zero convertibility to foreign currency. Some people are paid (and tourists receive) the `convertible' peso (CUC) which is 25 times more valuable. Thus there is a fixed, internal exchange rate. The CUP has zero convertibility internationally, while the CUC is partially convertible, for certain transactions. The CUC is pegged to the USD at 1:1. The CUC was introduced in 1994 (after the fall of the USSR) so as to avoid the use of the USD within Cuba. But it is about to be phased out within the next several years. At that point, Cuba will no longer have a dual currency. Presumably it will continue to have foreign exchange controls and a fixed exchange rate, but that will be very interesting to see..
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