A model of dual exchange rates applied to Belgium and Mexico

Dual exchange rates are characterized by the existence of one exchange rate for financial transactions and another controlled rate for commercial transactions. The interest in dual exchange rate systems stems partly from their practical relevance: even in countries that have not formally adopted such a system, it is frequently the case that convertibility restrictions result in black markets for foreign exchange that operate in a similar fashion to dual exchange rate systems.; This study analyzes the effects of dual and black markets for foreign exchange on the economy. Two models are developed. The first model could account for the experience of European countries with dual rates characterized by unrestricted access to the foreign exchange markets. The second model would account for the experience of countries in which foreign exchange controls remain in place, giving rise to a black market. The black market rate becomes the relevant one for a number of transactions, including capital account ones. This extension departs from previous models in the literature since it is found that in some contexts a black market rate also affects the portfolio composition of the public. Black markets in foreign exchange not only introduce a goods' market distortion, but also an intertemporal one.; The two optimizing asset pricing models are distinguished by the introduction of a black market and liquidity constraints. Different expressions for the spread are derived from the conditions of maximization, which will be used in the empirical part of the study.; The models are applied to the experiences of Belgium and Mexico. The Generalized Method of Moments is used to recover the underlying time preference parameters and the coefficients of relative risk aversion. Finally, the models are simulated using the method of Parameterized Expectations, in order to determine which properties of the observed data are being successfully replicated. The performance of the models is evaluated and it is concluded that some of the stylized facts of the behavior of exchange rates in Belgium and Mexico are well captured by the model.