ABSTRACT
It is widely known that the existence of ‘dual’ rates in the foreign exchange markets - one officia l and the other ‘u n o ffic ia l’ - has im portant implications for the conduct of exchange rate policy in less developed countries (LDCs) (see, e.g. Dombusch, 1993; Phylaktis, 1995, for a good review). The two exchange rate markets are separated mainly because of the presence of exchange rate risk premiums, interest rate differentials (foreign and domestic) and expected rate of exchange rate depreciation. Exchange rate distortions can also occur due to government interventions in the foreign exchange market, associated trade controls and mis-invoicing, and problems of moral hazards and adverse selections as perceived by the international lenders to LDCs. Alternatively, chronic and persistent balance of payments problems, presence of trade controls, tariffs and quotas, and financial distortions, such as rapidly accelerating domestic inflation and interest rates vis-a-vis foreign rates, can lead to the emergence of black markets (BM) in exchange rates. These BM rates, if unconnected with the official rates, could render the official exchange rate impotent as an instrument to control the trade balance and foreign exchange reserves. Besides, they impose substantial costs on the economy due to the misallocation of resources at both the macro and micro levels, as there are many links between the domestic economy and the rest of the world. The linkage to the goods market can be summarised in terms of the real exchange rate (R) which is the ratio of foreign prices in Rupees to domestic prices in Rupees, i.e.
