Abstract
Abstract This paper aims to analyse the dynamics of foreign exchange markets in a country facing political uncertainty that prompt capital outflow from the country1. The economic environment under investigation is characterized by dual foreign exchange markets: a formal or official market for foreign exchange with insufficient and volatile foreign exchange flows, and a strong and thriving informal market, with a higher exchange rate2. The findings in the paper indicate a necessary condition for stabilization of the exchange rate system and that is that the return on investment should exceed the depreciation rate of domestic currency in the formal foreign exchange market. This condition implies that the return on investment should at least compensate investors for the opportunity cost of holding domestic money in their private portfolio wealth. Our findings also indicate that stability of the foreign exchange rates is more difficult to achieve under insufficient official reserves as the recovery process from a shock becomes more costly in terms of time period needed for the adjustment process to complete. The dynamic path of the foreign exchange premium shows that under massive capital outflow caused by economic sanctions, the informal market exchange rate overshoots the equilibrium stationary exchange rate, and the size of such overshooting depends on the size of available foreign exchange reserves held by the central bank.
Highlights
The increasing importance of studying dual foreign exchange markets in some developing countries over the past few years is possibly due to the increasing role of the informal markets for foreign exchange in the economies of these countries despite successive attempts by some governments to curb the role of these markets in the economy
The paper employs the partial equilibrium dynamic model to assess the impact of economic sanctions against a small and open economy on dynamics of foreign exchange markets
The paper attempts to answer the following questions: What is the necessary condition needed to stabilize the foreign exchange rates under such dual foreign exchange system? Does the informal market rate approximate steady state equilibrium exchange rate? Is it possible to sustain unified single exchange rate system? What is the appropriate policy needed to ease the adverse impact of economic sanctions that prompt capital outflow?
Summary
The increasing importance of studying dual foreign exchange markets in some developing countries over the past few years is possibly due to the increasing role of the informal markets for foreign exchange in the economies of these countries despite successive attempts by some governments to curb the role of these markets in the economy. Informal markets for foreign exchange have a large number of dealers, where the price of foreign exchange is determined according to supply and demand forces for foreign currencies. The increasing sensitivity of major economic indicators in underdeveloped economies to volatility in informal markets for foreign exchange highlights the importance of modelling dynamic aspects of these markets. The current paper is motivated by the need to set up a dynamic model with optimization features to capture volatility boundaries in currency markets facing internal and external shocks. The contribution of the paper entails setting up a macroeconomic model of dual foreign exchange markets and combines the impact of external economic sanctions on a country with internal factors such as capital flight and political unrest to answer the following questions: Is it possible to stabilize the foreign exchange rates under such political and economic environment? Section four includes the analysis, and the final section concludes the study
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