When faced with a sudden shock to its economy, a country can opt to implement a dual or multiple foreign-exchange rate system. With this type of system, a country has more than one rate at which its currency is exchanged. So, unlike a fixed or floating system, the dual and multiple systems consist of different rates, fixed and floating, that are used for the same currency during the same period of time.
In a dual exchange rate system, there are both fixed and floating exchange rates in the market. The fixed rate is only applied to certain segments of the market, such as "essential" imports and exports and/or current account transactions. In the meantime, the price of capital account transactions is determined 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).
In a multiple exchange rate system, the concept is the same, except the market is divided into many different segments, each with its own foreign exchange rate, whether fixed or floating. Thus, importers of certain goods "essential" to an economy may have a preferential exchange rate while importers of "non-essential" or luxury goods may have a discouraging exchange rate. Capital account transactions could, again, be left to the floating exchange rate.
Why More Than One Rate?
A multiple system is usually transitional in nature and is used as a means to alleviate excess pressure on foreign reserves when a shock hits an economy and causes investors to panic and pull out. It is also a way to subdue local inflation and importers' demand for foreign currency. Most of all, in times of economic turmoil, it is a mechanism by which governments can quickly implement control over foreign currency transactions.
Such a system can buy some extra time for the governments in their attempts to fix the inherent problem in their balance of payments. This extra time is particularly important for fixed currency regimes, which may be forced to completely devalue their currency and turn to foreign institutions for help.
How Does It Work?
Instead of depleting precious foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market. Changes in the free-floating rate will reflect demand and supply.
The use of multiple exchange rates has been seen as an implicit means of imposing tariffs or taxes. For example, a low exchange rate applied to food imports functions like a subsidy, while the high exchange rate on luxury imports works to "tax" people importing goods which, in a time of crisis, are perceived as non-essential. On a similar note, a higher exchange rate in a specific export industry can function as a tax on profits.
Is It the Best Solution?
While multiple exchange rates are easier to implement, some economists argue that the actual implementation of tariffs and taxes would be a more effective and transparent solution. The underlying problem in the balance of payments could thus be addressed directly.
While the system of multiple exchange rates may sound like a viable quick-fix solution, it does have negative consequences. More often than not, because the market segments are not functioning under the same conditions, a multiple exchange rate results in a distortion of the economy and a misallocation of resources.
For example, if a certain industry in the export market is given a favorable foreign exchange rate, it will develop under artificial conditions. Resources allocated to the industry will not necessarily reflect its actual need because its performance has been unnaturally inflated. Profits are thus not accurately reflective of performance, quality, or supply and demand. Participants of this favored sector are (unduly) rewarded better than other export market participants. An optimal allocation of resources within the economy can thus not be achieved.
A multiple exchange rate system can also lead to economic rents for factors of production benefiting from implicit protection. This effect can also open up doors for increased corruption because people gaining may lobby to try and keep the rates in place. This, in turn, prolongs an already inefficient system.
Finally, multiple exchange rates result in problems with the central bank and the federal budget. The different exchange rates likely result in losses in foreign currency transactions, in which case the central bank must print more money to make up for the loss. This, in turn, can lead to inflation.
The Bottom Line
An initially more painful, but eventually more efficient mechanism for dealing with economic shock and inflation is to float a currency if it is pegged. If the currency is already floating, another alternative is allowing a full depreciation (as opposed to introducing a fixed rate alongside the floating rate). This can eventually bring equilibrium to the foreign exchange market.
On the other hand, while floating a currency and allowing depreciation may both seem like logical steps, many developing nations are faced with political constraints that do not allow them to devalue or float a currency across the board: The "strategic" industries of a nation's livelihood, such as food imports, must remain protected. This is why multiple exchange rates are introduced—despite their unfortunate capacity to skew an industry, the foreign exchange market, and the economy as a whole.