Import Controls and Devaluation-Inflation Spiral

Abstract

Using a model of dual foreign exchange markets: an official market with a crawling-peg foreign exchange rate and illegal parallel market with a free-floating rate2, the paper shows that the adoption of a restrictive import policy in the official market raise the equilibrium parallel market premium rather lower it. The paper also shows that under a fixed (or adjustable peg) exchange rate policy and with an increasing domestic money supply the use of periodic devaluations of the official exchange rate in order to restore official reserve loss could lead to a devaluationinflation spiral and to eventual collapse of the fixed exchange rate regime. The expressions “parallel”, “informal”, and “black” are used interchangbly in the literature. However, in this paper the expression parallel is used to indicate illegal, active, and visible foreign exchange market.