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I present a model of a dual exchange rate regime and use it to examine the effects of

monetary issuances on interest rates, inflation, the parallel exchange rate and the current
account and reserves. The motivation is Argentinas cepo, with an official commercial rate controlled by the central bank and an unofficial (illegal black market) parallel
financial market rate.

Simple Two Period Model

This section presents a simple two-period model. An infinite-horizon model is spelled out
in greater detail in the next sections, and it is shown that these can justify the two-period
setting presented here, by collapsing all future periods into a single period.
There are two periods t = 0 now and t = 1 future. In the current period we have
the relations
= L(c, i )
P = D (c)e

e 0
,c ,c
B0 = B (1 + i ) + y c
c is consumption of traded goods (not total consumption here); c0 is next periods
consumption of traded goods;
P is the price of non-traded goods (or we could make it the CPI weighing traded
and non-traded goods);
i is the nominal domestic interest rate, endogenous;
i is the foreign interest rate, exogenous;
B is government reserves in foreign assets;
y is a fixed endowment of traded goods i.e. commodities
L is demand for real money balances, increasing in c and decreasing in i
e is the commercial exchange rate at t = 0; the future commercial exchange rate is
e0 .


Figure 1: The two equilibrium relations determining c and c0 . Also shown is the effect of
an increase in money supply M.
D is increasing in c i.e. more traded good consumption leads to an appreciation; it
is derived from relative demand for T and NT goods;
g is increasing in c0 and decreasing in c, i.e. a higher interest rate increases c0 decreases c or both; it is also increasing in e0 /e; this comes from the consumption Euler
equation; note: this relationship is simplified in that it should also depend on the
foreign price of traded goods but I am taking them as given, so I omit their presence
in the relation to simplify expressions.
There are two more relations in the model. We have the UIP condition
1 + i = (1 + i )


where e represents the financial or parallel exchange rate, a legal or illegal market for
foreign currency/assets. One should think of this as an indifference condition between
local and foreign assets. In addition
in general e 6= e

we will assume that e0 = e0 , i.e. in the future the dual market will converge into a
single market, implying
e = (1 + i )
combining this with the particular form that g(e0 /e, c0 , c) takes one can show that e is
increasing in e, increasing in c and decreasing in c0 (this is not obvious just knowing
the qualitative features of g mentioned above; but it follows from the model spelled
out in the next section)
The other important relation connects future consumption and future reserves
c0 = ( B0 )
where is increasing. This is what allows us to subsume the entire future equilibrium in
the full infinite horizon model into this two period version. This captures two things: (i)
in the full model the set of possible equilibria do depend on foreign reserves, in particular,
more reserves allows for higher consumption of traded goods; (ii) we are making a selection of the equilibrium that follows which subsumes all future fundamentals as well
as monetary and fiscal policy. Importantly, we assume that the equilibrium selected does
not change with the comparative statics we perform in the first period, at least insofar the
relationship between c0 and B0 .
To solve the model simply substitute the first three equations to get
M = eD (c) L(c, g(e0 /e, c0 , c)).


For given M this implies an upward relationship between c and c0 . The equilibrium can
be seen as the intersection of this schedule with the downward sloping schedule between
c and c0 given by
c 0 = ( B (1 + i ) + y c ) .
i, B are uniquely deterImportantly, once c and c0 are solved all the other variables P, e,
Taking e and e0 as given, the figure shows the resulting equilibrium as the intersection
of two schedules, representing equations (1) and (2). An increase in money supply M
leads to higher present consumption c and lower future consumption c0 . By implication,
it leads to lower future reserves B0 , a higher price P and lower interest rate i. Using the
UIP condition e = (1 + i ) 1e+i this then implies that e increases. The current account is
equal to the change in reserves. Thus, it deteriorates as money supply increases.

Proposition 1. Suppose we have a dual exchange regime at t = 0 but a unified exchange rate at
t = 1. Given e, e0 and e0 = e, an increase in money supply M leads to an increase in prices P, a
a decrease in the nominal interest rate i, an increase in
increase in the financial exchange rate e,
current consumption c and a decrease in future consumption c0 , decrease in reserves B0 .
Note that there is a value of M such that e = e, so that the financial and commercial
exchange rates coincide. The equilibrium in the dual market model is then equivalent to
that of an integrated exchange rate market.
We can also analyze cases where current policy does not set M exogenously. For example, suppose the government sets the nominal interest rate i. At each point along the
downward sloping green schedule there is a unique interest rate given by g(c0 , c). The
further down we move this schedule the lower the interest rate i. Thus, a policy that sets
the domestic interest rate i at a given level selects a particular point (c, c0 ) on this schedule
associated with this level of the interest rate. The rest of the equilibrium variables can be
uniquely determined. Indeed, we can find the value of M so that the upward sloping
schedule goes through the selected point (c, c0 ) on the downward sloping schedule.
Another example is if the government targets a given level of reserves B0 . This directly pins down future consumption c0 = ( B0 ). We can then find current consumption
using the downward sloping schedule. Thus, we have selected a pair (c, c0 ). Again, we
can then find the level of M that ensures that the upward sloping schedule goes through
this selected point (c, c0 ). The rest of the variables are uniquely determined as before.
Proposition 2. Suppose we have a dual exchange regime at t = 0 but a unified exchange rate at
t = 1, with given e, e0 and e0 = e0 . If the government targets the interest rate rate i or reserves B0
there is a unique equilibrium.
It follow from these propositions that the government cannot simultaneously pursue
a policy targeting money supply and reserves, for example. It must choose to exclusively
target monetary emissions, the domestic nominal interest rate or reserve accumulation.
Up to this point I have maintained e and e0 constant, I now discuss changes in these
variables. First, note that if M, e and e0 change proportionally, then this does not induce
or require any change in real variablesa standard neutrality result.
Proposition 3. Suppose we have a dual exchange regime at t = 0 but a unified exchange rate at
i, B0 , then the unique equilibrium with
t = 1. If e, e0 = e0 , M lead to an equilibrium c, c0 , P, e,
= M has c, c0 , i, B0 unchanged and e = e and P = P.
e = e, e0 = e, e0 = e0 , M
Next, suppose we hold M and e fixed, but increase e0 . Perhaps this is the result of an
increase in anticipated M0 . We can also view this exercise as relevant when combined

with the previously analyzed increase in M, i.e. higher M today may signal higher M0
and e0 . In terms of the diagram, the effect of an increase in e0 is similar to an increase in
M, shifts the upward schedule to the right, causing a decrease in c and increase in c0 . The
effect on i = g(e0 /e, c, c0 ) is to increase i (recall that g is increasing in e0 ).
Proposition 4. Suppose we have a dual exchange regime at t = 0 but a unified exchange rate at
t = 1. An increase in e0 = e0 holding e and M fixed leads to an increase in current consumption c,
a decrease in future consumption c0 , a decrease in reserves B0 , an increase in the nominal interest
rate i, an increase in prices P, and an increase in the financial exchange rate e (but increase e0 /e
What about a proportional change in both M and e0 ? We can think of this in two steps:
first, as a proportional change in all three variables e, e0 and M for which we have the
neutrality result above and second, a decrease in e. Thus, we need only study a decrease
in e. The next result tells us the implications of a lowering in e.
Proposition 5. Suppose we have a dual exchange regime at t = 0 but a unified exchange rate at
t = 1. A decrease in e holding e0 and M fixed leads to an increase in consumption c, a decrease in
future consumption c0 and reserves B0 .
It is useful to consider the benchmark with unified exchange rates.
Proposition 6. Suppose we have a unified exchange regime at both t = 0 and t = 1. All equilibria
share the same real allocation for consumption c, c0 and reserves B0 , real money balances M/P.
TO BE DONE. For given M what are the effects of introducing a dual exchange rate?
Is it the same as pushing the current commercial rate down? By how much?

Currency Controls/Capital Controls

Model structure
infinite horizon in discrete time t = 0, 1, . . .
for simplicity: no uncertainty
endowment economy: traded and non-traded goods
competitive markets

Consumer problem: given endowments {y Nt , y Tt } taxes { Tt } initial debt B0 money

M0 the agent solves:


u(c Nt , c Tt ) + h

{c Nt ,c Tt ,Bt+1 ,Mt+1 } t=0

Mt + 1
p Nt

subject to
p Nt c Nt + p Tt c Tt + Mt+1 + Bt+1

p Nt y Nt + p Tt y Tt + Mt + (1 + it1 ) Bt Tt
and No-Ponzi condition

t +1
Remark: note that real balances p Nt
divide by the price of non-traded goods only;
this is just to simplify; one justification would be that money is used only to purchase non-traded goods.

Exchange rate policy:

Commercial exchange rate {et } for exports and imports;
importers and exporters are forced to use this exchange rate for all commercial
international transactions (i.e. if you sell abroad you must give your dollars
to the central bank; if you buy abroad you must buy dollars from the central
bank); we abstract from evasion.
free trade implies the law of one price
p Tt = pt et
where { pt } is given international path for traded good
Government can be seen as having two separate budget constraints (i.e. laws of
motion for different assets)
domestic constraint in pesos
international reserves in dollars
Government international reserves account
y Tt c Tt gTt = dollars coming in = Bt+1 Bt (1 + it1 ) = investment abroad

and no Ponzi
lim qt Bt = 0

together imply

qt (yTt cTt gTt ) = B0 (1 + i 1 )

t =0

qt =


1 + i0 1 + i1
1 + it1

Market clearing
c Nt + g Nt = y Nt
Domestic government budget in pesos is
Tt + Mt+1 + Bt+1 = Mt + (1 + it1 ) Bt + p Nt g Nt + et (y Tt c Tt )
substituting into consumers budget we recover
p Nt (c Nt + g Nt y Nt ) = 0
the market clearing condition. Thus, this budget constraint is redundant, as usual.
first order conditions

Mt + 1
p Nt

= u Nt (c Nt , c Tt )

1 + it

u Nt (c Nt , c Tt )
= Nt
u Tt (c Nt , c Tt )
p Tt
u Tt (c Nt , c Tt ) = (1 + it )

p Tt
p Tt+1

u Tt+1 (c Nt , c Tt )

We can write the first condition as

Mt + 1
= L(c Tt , c Nt , it )
p Nt
Summarizing the equilibrium conditions (we have substituted the Law of One Price
and the market clearing condition)
Mt + 1
= L(c Tt , y Nt g Nt , it )
p Nt


u Nt (y Nt g Nt , c Tt )
= Nt
u Tt (y Nt g Nt , c Tt )
et pt


et+1 pt+1
u Tt (y Nt g Nt , c Tt )
1 + it =

et pt u Tt+1 (y Nt+1 g Nt+1 , c Tt+1 )


qt (yTt cTt gTt ) = B0 (1 + i 1 )


t =0

we can add the consumer budget constraint to determine the set of bond and taxes,
B and T, consistent with an equilibrium (as usual, there is a Ricardian equivalence
that implies there are infinitely many such pairs).
Lets see how we might use the equilibrium conditions for a few different government policy
1. Suppose government sets the domestic interest rate path {it }...
this determines path for {c Tt } using equations (5) and (6)
this then determines the path for p Nt using equation (4)
we can then back out the money sequence { Mt } from equation (3)
2. Government sets a path for money { Mt }
combining (3) and (4) we get
u Nt (y Nt g Nt , c Tt )
L(c Tt , y Nt g Nt , it ) = t+1
u Tt (y Nt g Nt , c Tt )
et pt
solving out it from the Euler equation (5) and substituting we arrive at a
difference equation
f (c Tt , c Tt+1 , t) = t+1
et pt
for some f function that is increasing in c Tt and decreasing in c Tt+1 (it depends on calendar time due to its dependence on y Nt , g Nt etc.); using this
condition together with the international budget (6) pins down a unique
{c Tt }.
from here we can proceed as in the previous policy exercise
3. Government sets a path for reserves (consistent with the no-Ponzi condition)
this directly implies a path for consumption
c Tt = Bt (1 + it1 ) Bt+1 gTt + y Tt

from here we can continue as before

4. Suppose government requires some exogenous seignorage {St } so that
St =

Mt + 1 Mt
= t+1 Nt1
p Nt
p Nt
p Nt p Nt1

This case requires solving a fixed point problem that I am not sure is triangular
in the same way as the other cases discussed above.
St = L(c Tt , y Nt g Nt , it )

Mt +1
p Nt

L(c Tt1 , y Nt1 g Nt1 , it1 )
p Nt

= L(c Tt , y Nt g Nt , it ) we obtain

St =

Mt + 1

L(c Tt , y Nt g Nt , it )

St = L(c Tt , y Nt g Nt , it )

u Nt (y Nt1 g Nt1 , c Tt1 )

u Tt (y Nt g Nt , c Tt )
L(c Tt1 , y Nt1 g Nt1 , it1 )
u Nt (y Nt g Nt , c Tt )
u Tt (y Nt1 g Nt1 , c Tt1 )

Q: What about the financial or parallel exchange rate?

A: imagine there is a financial exchange rate et i.e. someone transfers you one dollars
to a US account in exchange for an opposite transfer of et in pesos in Argentina. Then
it must satisfy the no-arbitrage condition

(1 + it )

= (1 + i t )

where {et } is the parallel exchange rate.

note that the differential rate of depreciation is related to the allocation and world
interest rates by
pt+1 /pt
u Tt (y Nt g Nt , c Tt )
et+1 /et+1
et /et
u Tt+1 (y Nt+1 g Nt+1 , c Tt+1 ) 1 + it
This equation does not pin down the level of E t , only its level, we can pin down the
level if we think there is some future date T at which point the official and parallel

exchange rates merge:

eT = eT
this then pins down the entire sequence {et } given eT and {it , it }.

Free Currency
suppose instead you can buy FX at Et for any purpose
then we simply have Et = E t for all t
we get the equation

(1 + it )

= (1 + i t )

together with the previous conditions

Mt + 1
= L(y Nt g Nt , it )
p Nt
u Nt (y Nt g Nt , c Tt )
= p Nt
u Tt (y Nt g Nt , c Tt )
1 + it =

u Tt (y Nt g Nt , c Tt )
u Tt+1 (y Nt+1 g Nt+1 , c Tt+1 )

qt (yTt cTt gTt ) = B0 (1 + i 1 )

t =0

Sticky prices [to be completed]

now consider nominal rigidities, so we need to consider production of c N , so that
y Nt is no longer fixed
with rigid prices we take the sequence of { p NT } as given and we drop the condition
that output y Nt is exogenous (instead it is now defined by c Nt + g Nt = y Nt ) so that

Mt + 1
p Nt

1 + it

u Nt (c Nt , c Tt )
= p Nt
u Tt (c Nt , c Tt )


1 + it =

u Tt (c Nt , c Tt )
Et u Tt+1 (c Nt , c Tt+1 )

qt (yTt cTt gTt ) = B0 (1 + i 1 )

t =0

For example, if p Nt is constant then with homogeneity we have c Nt c Tt and then

using the Euler equation and budget constraint we can compute the path for consumption given a path for interest rates; finally we can back out the needed money
supply to satisfy the first condition.
If instead we take a path of M as given, e.g. to pay for some seignorage, then we use
the first equation to solve for it and then use the last two to solve for consumption.