Abstract:
This paper addresses the merits of using the parallel exchange rate as a guide to setting the official
exchange rate. Ideally, policymakers would set the exchange rate at the level that would balance trade
and sustainable capital flows--that level is referred to as the equilibrium exchange rate. In practice, it
is difficult to identify the equilibrium exchange rate, particularly in countries that have experienced
macroeconomic volatility and/or structural change. In this context, where parallel markets for foreign
exchange exist, it is natural to consider the parallel rate as a proxy for the equilibrium exchange rate,
since it is set directly by the market. The paper develops an analytic model to explore the relationship
between the parallel exchange rate and the equilibrium rate. It is determined that only under a fairly
narrow set of circumstances will the parallel rate be set at a level close to the equilibrium exchange
rate. The paper then compares the evolution of official and parallel exchange rates over time, in a
large sample of different countries, to provide a feel for the applicability of the previously-derived
theoretical results.
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