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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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