The black market premium and the rate of inflation in a dual exchange rate regime

Abstract

This paper examines the relationship between the black market premium and the rate of inflation under a dual exchange rate regime consisting of an official market and a black market. By explicitly specifying the implicit export tax associated with the government budget constraint in a dynamic optimizing context, the paper demonstrates that (1) for any given long-run rate of inflation, there exist two steady-state equilibria corresponding to a high premium and a low premium, and that (2) an increase in the rate of crawl of the official exchange rate has two effects on the premium, namely, the financing effect and the portfolio effect. Therefore, the conventional view that a trade-off exists between the black market premium and the rate of inflation when the inflation elasticity of money demand is less than unity does not generally hold. It is also shown that, although the implicit export tax vanishes when the two exchange rates are unified, the inflation tax may not increase because the unification increases the explicit export tax. This result also differs from the conventional view. Copyright © 2000 John Wiley & Sons, Ltd.