Credibility and parallel foreign currency markets

During the last 25 years, many developing countries have adopted dual exchange systems in which separate exchanges rates are used for commercial and capital account transactions. Ostensibly, the objective of these systems was to insulate economies from adverse shocks. In other cases, unofficial parallel markets for foreign exchange developed in response to capital controls imposed by governments.; A benchmark model is developed in which there are two exchange rates. The official exchange rate is fixed by the monetary authority and the parallel market exchange rate is freely determined. The credibility of the official exchange rate is measured by the percentage difference between the official and parallel exchange rates. A high premium indicates that the official exchange rate lacks credibility. A unification of the exchange rate system is defined as setting all exchange rates equal to the exchange rate existing in the freely determined market. Our benchmark model is used to assess the consequences of unification under conditions under different credibility conditions. We find that when unification is undertaken when the official exchange rate lacks credibility the result is inflationary.; Three implications of the benchmark model is tested using monthly data for Guyana, Trinidad and Jamaica for the period 1985:1 to 1993:12. These countries are chosen because they represent economies which responded to crisis by pursuing expansionary fiscal policy. Our findings are that exchange rate reform undertaken in Jamaica during the sample period were credibility enhancing while exchange reform undertaken in Guyana and Trinidad had mixed effects on credibility.; Some of the contributions of this dissertation are (i) it establishes clear linkages between credibility and the existence of parallel markets for foreign currency; (ii) it utilizes first order regime switching techniques to test the credibility of the official exchange rate regime; (iii) it emphasizes the variety of macroeconomic circumstances in which credibility issues can arise and, (iv) it highlights issues unique to exchange rate management in developing countries.