Exchange Rates 101: Dual and Multiple Exchange Rates

Exchange Rates 101: Dual and Multiple Exchange Rates

Whenever a country’s economy experiences a sudden shock, it has the option of implementing a dual or multiple foreign-exchange rate system. An one country may have more than one rate at which its currency is traded under this type of system. To put it another way, in contrast to a fixed or floating system, the dual and multiple systems are comprised of various rates, both fixed and floating, that are utilized for the same currency within the same period of time.

There are both fixed and variable exchange rates available in the market when a dual exchange rate system is in place. Specific segments of the market, such as “important” imports and exports and/or current account transactions, are subject to the fixed rate, which is solely applicable to those segments. The price of capital account transactions, in the meantime, is set by a market-driven exchange rate (so as not to hinder transactions in this market, which are crucial to providing foreign reserves for a country).

Multiple exchange rate systems operate on the same principles as single exchange rate systems, with the exception that the market is divided into several different parts, each with its own foreign exchange rate, which may be fixed or floating. It is possible that the exchange rate for importers of certain commodities that are considered “important” to an economy will be more favorable than the exchange rate for importers of goods that are considered “non-essential” or “luxury.” It is possible that capital account transactions will be subject to the variable exchange rate once more.

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What’s the point of having more than one rate?

The nature of a multiple system is usually transitional, and it is used to relieve excess pressure on foreign reserves when a shock hits an economy, causing investors to fear and take out of the market. It also serves as a means of regulating local inflation as well as the desire for foreign currency by importers. Most importantly, it provides a method for governments to quickly adopt control over foreign currency transactions during times of economic crisis.

It is possible that such a system will buy the governments some further time in their efforts to correct the underlying problem with their balance of payments. This additional time is particularly critical for fixed-currency regimes, who may be compelled to weaken their currencies totally and seek assistance from international financial institutions.

What is the procedure?

By diverting the high demand for international currency away from precious foreign reserves and onto a free-floating exchange rate market, the government avoids depleting its valuable foreign reserves. The free-floating rate will fluctuate in response to changes in demand and supply.

When several exchange rates are used, it has been interpreted as an implicit manner of imposing tariffs or taxes on goods and services. For example, a low exchange rate applied to food imports has the effect of a subsidy, whereas a high exchange rate applied to luxury imports has the effect of “taxing” persons who purchase things that are thought to be non-essential during a time of economic distress. In a similar vein, a higher exchange rate in a certain export industry can have the effect of imposing a profit tax on the company.

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Is It the Most Effective Solution?

Despite the fact that numerous exchange rates are more straightforward to execute, some economists believe that the actual implementation of tariffs and taxes would be a more efficient and transparent approach. In this way, the underlying problem with the balance of payments might be addressed immediately. 1

While a system of different exchange rates may appear to be a reasonable short-term solution, it has severe repercussions in some circumstances. Because the market segments are not operating under the same conditions, a multiple exchange rate is more often than not associated with economic distortion and misallocation of scarce resources. 2

Consider the following scenario: If a specific industry in the export market is provided with a favorable foreign exchange rate, the industry will develop under artificial circumstances. Because the industry’s performance has been artificially overstated, the resources allotted to it will not necessarily correspond to its true requirements. Profits, as a result, do not correctly reflect performance, quality, or the relationship between supply and demand. Participants in this preferred sector are (inadvertently) compensated more generously than other participants in the export market. As a result, it is impossible to establish an optimal allocation of resources within the economy.

It is possible that a multiple exchange rate system will result in economic rents for sources of production that benefit from implicit protection. Additionally, because those who benefit from the rates may campaign to keep them in place, increased corruption may result as a result of this phenomenon. 3 This, in turn, prolongs the life of a system that is already inefficient.

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Finally, the existence of different exchange rates creates difficulties for the central bank and the federal budget. When the exchange rates fluctuate, it is possible that investors may suffer losses on their foreign currency transactions. In this situation, the central bank will be forced to print more money to compensate the investors. This, in turn, has the potential to cause inflation. 4

Finally, the bottom line :

An initially more painful, but ultimately more efficient technique for coping with economic shock and inflation is to allow a currency to float if it is currently linked to a currency of another country. If the currency is already floating, another option is to allow for a complete depreciation of the value of the currency (as opposed to introducing a fixed rate alongside the floating rate). The foreign exchange market may finally achieve equilibrium as a result of this.

Furthermore, while devaluing and floating currencies appear to be logical steps, many developing countries are constrained by political constraints that prevent them from doing so universally: the “strategic” industries that support a nation’s livelihood, such as food imports, must be protected from devaluation and flotation. This is why numerous exchange rates are established, despite the regrettable fact that they have the potential to skew an industry, the foreign currency market, and the economy in general.

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