Exchange Restrictions and the Monetary Approach to the Exchange Rate

The importance of monetary variables in the determination of the exchange rate in a regime of floating rates has recently been the object of careful theoretical and empirical studies, some of which are collected in this volume. ¹ . Many of these studies, however, have been carried out under the stated or the implicit assumption that restrictions to the international movement of capital are not present and, therefore, that market forces are the overwhelming determinants of the exchange rate. This paper presents an extension to the monetary approach to the exchange rate that analyzes the experience of countries where the presence of exchange restrictions leads to the development of a black market for foreign money. We postulate that in those cases the exchange rate in the black market is freely determined by market forces and responds to disequilibria in the domestic money market while the official exchange rate is administratively determined by the government responding to a reaction function that may be derived from a condition of utility maximization.