The Effect of Dual Exchange Rates System in a Financial Crisis: A Target Zone Perspective

Abstract

Based on the modified Froot and Obstfeld (1991a) simple stochastic macro model, this paper addresses the relative stabilizing performance of a dual exchange rate system from the viewpoint of target zones. We focus on an experiment in which the central bank implements a target zone policy in the commercial exchange market to maintain the commercial exchange rate within a specific band, but does not engage in any intervention in the financial exchange market, thus allowing the financial exchange rate to float freely. In contrast to the conventional wisdom, upon the shock of a change in commodity production, we find that the inverse movement of these two rates does not always occur under the target zone perspective. The relative elasticity of the real commercial rate to income in the balance of payments is the crucial point for the desirability of targeting the commercial rate. Therefore, in deciding whether to execute the commercial rate target zone, the central bank needs to consider the country`s condition and main goals; the issue may merit consideration in countries that have encountered an aggregate supply shock financial crisis situation.