University of Khartoum

The Impact of a Political Shock on Foreign Exchange Markets in Small Open Economy: A Dynamic Modeling Approach

The Impact of a Political Shock on Foreign Exchange Markets in Small Open Economy: A Dynamic Modeling Approach

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Title: The Impact of a Political Shock on Foreign Exchange Markets in Small Open Economy: A Dynamic Modeling Approach
Author: Onour, Ibrahim A.; Sergi, Bruno S.
Abstract: Background: The aim of this paper to analyze the dynamics of foreign exchange markets in a country facing political uncertainty that prompt capital outflow from the country1. The economic environment under investigation is characterized by dual foreign exchange markets: a formal or official market for foreign exchange with insufficient and volatile foreign exchange flows, and a strong and thriving informal market, with a higher exchange rate2. The paper seeks to answer a number of essential questions: Is it possible to stabilize the foreign exchange rates premium under recurring political instability that prompt capital outflow from the country? How possible is it, to sustain unified exchange rate system? Does the informal foreign exchange rate overshoots the sustainable stationary exchange rate? what determines the size of overshooting? And what is the appropriate exchange rate policy that mitigates adverse effect of economic sanctions on the country. Methods: The paper employs partial equilibrium dynamic modeling approach using optimum control theory to investigate the impact of a shock invoked by political unrest that causes capital outflow from the country. Results: The findings of the paper indicate a necessary condition for stabilization of the foreign exchange rates is that expected returns from investment should exceed the depreciation rate of the formal foreign exchange rate3.The size of overshooting of the informal market rate premium rises as the level of official reserves with the central bank declines. Our finding also indicate that unification of the dual foreign exchange markets can only be achieved when capital outflow remains at insignificant low levels, implying that sustainable unification of exchange rates cannot be achieved in an economy under economic sanctions that prompt capital outflow from the country. However, adoption of flexible exchange rate system that maintains a fixed informal market rate premium can mitigate the adverse effect of economic sanctions on capital outflow
URI: http://khartoumspace.uofk.edu/123456789/27609
Date: 2019


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