Annex 2B


an effective overvaluation of the local currency), demand for foreign exchange will exceed
supply, as the domestic price of tradables will be relatively depressed, encouraging demand
but discouraging production (see analysis of Salter-Swan-model in Annex 2A). Less foreign
exchange will become available through exports while more foreign exchange is demanded
for imports.

Figure B2-1: Balanced and Unbalanced Market of Foreign Exchange


 Price of $

 S'
 / s





 P, --- ,- --

 0n ----- q---q X d--------> -----^

 0 q --L Quantity of $


In order to maintain the nominal exchange rate below the equilibrium rate, additional foreign
exchange must be made available through foreign credits or a depletion of the country's
foreign exchange reserves. If these possibilities are exhausted, administrative measures
become necessary to restrict imports (e.g. through import licenses) and to control the foreign
exchange earnings from exports (in order to make sure that the foreign exchange from export
earnings is offered at the nominal rate on the official market).

In a situation of unbalanced supply and demand, a parallel market for foreign exchange is
likely to arise, with exchange rates well above the nominal rate. As the parallel market
exchange rate is more attractive for exporters (and any owners of foreign exchange who want
to change into local currency), the quantities of foreign exchange offered at the official rate
will further decline (shift of the supply curve of foreign exchange available on the official
market from S to S'), and the gap between supply and demand for foreign exchange will
further increase. On the other hand, importers who fail to obtain import licences are forced to
buy foreign exchange at the higher parallel market rates.

As a result of a multiple exchange rate system with official and parallel market rates, we get a
highly distorted price and market structure:

* relatively low prices of products imported at the official rate compared to the prices of
 products imported at the parallel market rate (even for the same type of goods);


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