An Experiment with Official and Parallel Foreign Exchange Markets in a Developing Country

Abstract

This classroom experiment shows under what conditions the parallel market rate approximates the free-market value of the domestic currency. In addition, the experiment demonstrates how the existence of an official exchange rate may suppress international trade and promote corruption. Students take the roles of foreign exchange traders in a developing country. Their government desires a higher value for its currency than the market-clearing exchange rate. However, the government does not have foreign currency reserves to sell in order to maintain this value. Instead, it establishes an official foreign exchange market in which it trades some currency at the overvalued rate. In the official market, the quantity demanded of foreign currency exceeds the quantity supplied, so a parallel foreign exchange market with a floating rate handles the excess demand. Kiguel and O'Connell (1995) describe such dual exchange rate systems as common in developing countries. Typically, a developing country establishes an official market with an over-valued exchange rate to avoid the inflationary effects of a depreciation. Sometimes the government formally establishes a parallel foreign exchange market as well. For instance, developing countries often establish an official exchange rate for commercial transactions and a floating rate for financial transactions. In other cases, the parallel markets arise spontaneously, with varying degrees of tolerance from the government; these markets are called a gray market. If the government penalizes trade in the parallel market, it is called a black market. We used this experiment in a monetary theory course to introduce the role of supply and demand in foreign exchange markets and in a principles of economics course as part of a unit on the effects of government price controls. We also used an earlier version of the experiment in intermediate macroeconomics to introduce the various forms of foreign exchange regimes and in an openeconomy macroeconomics course to illustrate the economic effects of an overvalued currency in a developing country. Instructors could also use it for the financial section of an international economics course or in a course in development economics.