Insulation Properties of a Two-Tier Exchange Market in a Portfolio Balance Model

Abstract

When countries peg their currencies to those of their major trading partners, they expose themselves to interest-sensitive and speculative capital flows that can undermine their ability both to maintain their exchange rate and to pursue an independent monetary policy. Some countries, notably France, Italy and the Belgo-Luxembourg Economic Union (BLEU), experimented with two-tier exchange rates in the early 1970s in the hopes of insulating their economies from the effects of international capital flows while at the same time protecting foreign trade from exchange rate fluctuations. France and Italy soon abandoned the experiment, but the BLEU continues to maintain separate exchange markets, with separate exchange rates, for current and capital account transactions. The commercial exchange rate, which relates to the market for current account transactions, is generally pegged by the authorities; the financial exchange rate, determined in the market for capital account transactions, is usually free to fluctuate. 1 This paper investigates how well a two-tier exchange market insulates a small open economy from foreign disturbances, taking into account recent developments in the theory of exchange rate determination. Work by Branson (1977), Dornbusch (1976), and Kouri (1976) suggests that the short-run equilibrium value of the exchange rate is determined, along with interest rates, by demand and supply in the markets for financial assets. This asset market-or portfolio balance-approach to exchange rate determination is particularly well suited to a study of the two-tier exchange market. One can view the financial exchange rate as a relative asset price. It is among the variables that equilibrate asset markets, and it is determined in the short run in those asset markets. Previous theoretical work on the two-tier exchange market has generally been within the Mundellian framework; the financial exchange rate has been treated as equating a flow demand and supply of foreign exchange. The asset market approach has the advantage of carefully distinguishing between stocks and flows. In particular, it treats demands for assets as stock demands that are realized instantaneously so that actual holdings of assets always reflect the desired composition of the portfolio. Disturbances to portfolio equilibrium create immediate stock adjustments as portfolios are rebalanced, causing instantaneous changes in endogenous market-clearing variables. In addition, disturbances alter the rate of accumulation (the flow) of financial assets over time. Portfolio balance models of two-tier exchange rates can be found in Dornbusch (1976) and Decaluwe and Steinherr (1976), but they differ from the one presented here. Dornbusch partitioned the exchange market so that interest income, a current account transaction, was channelled through the financial market. That segmentation yields a different expected rate of return on foreign