Theoretical and policy aspects of dual exchange rate systems

When facing persistent balance of payments problems, some countries have resorted to a dual exchange rate system as an alternative to a uniform exchange rate adjustment. Typically under the dual system, certain selected transactions take place at a fixed official exchange rate, while the remaining transactions take place at a more depreciated rate, which is usually determined by market forces. This paper examines certain macroeconomic aspects of the dual exchange rate system, such as the reasons for its adoption, the effects on the balance of payments, and the problems involved in unification of the rates. It is argued that dual exchange rate systems can be useful in neutralizing speculative capital flows and thus keep the external position from deteriorating while adjustments are made in domestic policies. The system cannot, however, be expected to maintain external balance in the long run if the authorities do not change their policy stance. The dual exchange rate system is also not without drawbacks. If significant differences arise between the two rates, leakages between the markets can develop which can be destabilizing. Furthermore, this system can be used to establish a disguised form of taxes and subsidies on international trade.