Parallel market exchange rates in developing and reforming economies

Sudeep Arora, Purdue University

Abstract

This thesis develops a model of black market for foreign currency that focuses on the interaction of portfolio decisions and the determinants of the net flows of black foreign currency. The model explicitly incorporates foreign exchange restrictions as well as the demands arising from smuggling. Furthermore, this study analyzes the short run and the long run reactions of the black exchange rate to changes in the law enforcement efforts and the penalties levied on illegal trading. The relationship between political risk, a factor ignored in the literature, and movements in the black market exchange rate is also investigated. Time series tests such as cointegration and error correction are used to analyze data from various developing countries, such as Brazil and India, to test predictions of the model. We find that foreign exchange restrictions are important and need to be considered before any predictions about the movement of the black market exchange rate can be made. We provide theoretical and empirical justification to elucidate the importance of the illegal character of the black market for currency. Empirical results using unique data set provide evidence that the authorities act in a way to restrict foreign exchange and encourage the acquisition of foreign exchange. Changes in political risk, a factor ignored in the literature, is shown to affect the movement in the black exchange rate. Overall, the theoretical model's long and short run predictions are supported by the data from Brazil and India.

Degree

Ph.D.

Advisors

Carlson, Purdue University.

Subject Area

Economics|Finance|Economic theory

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