Financial stability in small open economy under political uncertainty

Onour, Ibrahim (2011): Financial stability in small open economy under political uncertainty.

Abstract

In this paper we model financial stability in small open economy enduring political uncertainty and operating under dual exchange markets, a free exchange rate applicable to wide range of private capital transactions and controlled exchange rate applicable to some official transactions. The finding in the paper indicate, given that capital outflow is kept at minimal level there exist steady state equilibrium exchange rates. The level of initial official reserves determine the length of time needed for the process to adjust towards a new steady state equilibrium. The lower initial official reserve level is, the longer time is needed to recover from a shock and adjust towards a new equilibrium steady state. When fiscal deficit and declining official reserves force the government to abandon the dual exchange system in favor of floating single exchange rate system, our model predict depreciation of foreign exchange rates is identical to domestic money growth.

• Item Type: MPRA Paper
• Language: English
• Keywords: parallel rate, official rate, Stability, Steady-state.
• Subjects: O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O11 - Macroeconomic Analyses of Economic Development; C - Mathematical and Quantitative Methods > C0 - General > C02 - Mathematical Methods; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy

References

Dornbusch, R., Pechman, D., Rocha, R., and Simoes, D., “The Black Market for Dollars in Brazil,” Quarterly Journal of Economics, 98, Feb. 1983, 25-40. Edwards, S., Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries (Cambridge, Mass., MIT Press, 1989). Gros D., “Dual Exchange Rate in the Presence of Incomplete Market Separation: Long-Ran Effectiveness and Implications for Monetary Policy” IMF, WP/87/45,1987 Jadgeep B., Vegh C., “Dual Exchange Markets Under Incomplet Separation: An Optimizing Model,” IMF Staff Papers, Vol. 37, No.1 March 1990. Kharas, H., and Pinto, B., “Exchange Rate Rules, Black Market Premia, and Fiscal Deficits: The Bolivian Hyperinflation,” Review of Economic Studies, 56, July 1989, 435-47. Kiguel, M., O’Connell, S., “Parallel Exchange Rate in Developing Countries.” The World Bank Research Observer, Vol. 10, No.1, Feb. 1995, 21-52. Lizondo, J. S., “Unification of Dual Exchange Market,” Journal of International Economics, 22, Feb. 1987, 57-77. Onour, I., and Cameron, N., “Parallel Market Premium and Real Official Exchange Rate Misalignment,” Journal of Economic Development, Volume 22, Issue No.1, 1997, 25-41. Onour, I., “Unification of Dual Foreign Exchange Markets” Economics of Planning (Journal),33, 171-184, 2000. Rodriguez, C., “A Stylized Model of the Devaluation-Inflation Spiral” IMF Staff Papers, 25 , 1978, 76-89. Pinto B., “Black Market Premia, Exchange Rate Unification and Inflation In Sub-Saharan Africal” World Bank Economic Review, 3, Sep. 1989, 321-38. ------, “Black Markets for Foreign Exchange, Real Exchange Rates, and Inflation” Journal of International Economics,” 30, March 1991, 121-35. Kant, C., (2002) “What is Capital Flight?, The World Economy, Vol.22, Issue 2, pp.341-358.