Currency Inconvertibility, Portfolio Balance and Relative Prices

Abstract

This paper analyzes regimes of currency inconvertibility in the framework of a simple general equilibrium model where exports and imports are either officially traded or smuggled and where a non-traded good is also produced and consumed. Residents allocate financial wealth between domestic currency and “black” market foreign exchange. It is shown that stability requires the effect of relative prices on the demand for goods to dominate their effect on the demand for assets.A once-and-for-all devaluation of the official exchange rate does not change the currency composition of private financial wealth, but a constant rate of change of the official rate (the crawling peg) does. The direction of the effect of monetary policy on the currency ratio depends on the nature of expectations about relative asset returns. If expectations are “rational” or “hyperopic”, an increase in the rate of crawl increase the return on foreign currency and hence the currency substitution ratio whereas, if expectations are static, it may reduce it.