Contractionary devaluation with black markets for foreign exchange

Abstract

Analyses of the possible contractionary effects of exchange rate devaluation typically assume the foreign exchange market to be unified, thereby ignoring the large fraction of transactions taking place in the black markets for foreign exchange that exist in many developing countries. This paper explores how the existence of these black markets may alter the impact of an official devaluation on aggregate output. It is argued that devaluation will be followed by less immediate contraction in a black market economy than in a unified market economy, both because the black market exchange rate will depreciate by less than the official rate, and because many of the devaluation's contractionary effects will occur in anticipation of the official devaluation itself. These propositions are tested using a simple numerical simulation model.