Exchange rate reforms in developing countries have often consisted in floating the exchange rate in an attempt to unify the official and parallel markets for foreign exchange. This paper examines the behavior of output, prices, foreign reserves, and the trade balance in anticipation of such reforms.
The analysis is first conducted in the context of a simple model that explicitly accounts for leakages between foreign exchange markets and examines their effect on official reserves. The model indicates that a future unification leads, at the moment the announcement is made, to an immediate depreciation of the parallel exchange rate with no change in the stock of foreign reserves. During the transition, the parallel exchange rate keeps depreciating (and the premium keeps rising), while net foreign assets keep falling—both at an accelerating rate. No “jumps” occur when the reform is actually implemented, at which point the parallel market premium drops to zero.
The model is then extended to incorporate sticky prices and forward-looking wage contracts and to endogenize output and the real exchange rate. The analysis indicates that the implications of the simplified framework regarding official reserves and the parallel market premium remain largely unaltered. In addition, the extended model suggests that, during the transition, a preannounced reform may be associated with an appreciation of the real exchange rate and a fall in output.