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The impact of a political shock on foreign exchange markets in a small and open economy: A dynamic modelling approach

Author

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  • Ibrahim A. Onour

    (Department of Business Administration, University of Khartoum, Sudan)

  • Bruno S. Sergi

    (University of Messina, Messina, Italy & Harvard University, Cambridge, USA)

Abstract

This paper aims to analyse the dynamics of foreign exchange markets in a country facing political uncertainty that prompt capital outflow from the country. 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 rate. The findings in the paper indicate a necessary condition for stabilization of the exchange rate system and that is that the return on investment should exceed the depreciation rate of domestic currency in the formal foreign exchange market. This condition implies that the return on investment should at least compensate investors for the opportunity cost of holding domestic money in their private portfolio wealth. Our findings also indicate that stability of the foreign exchange rates is more difficult to achieve under insufficient official reserves as the recovery process from a shock becomes more costly in terms of time period needed for the adjustment process to complete. The dynamic path of the foreign exchange premium shows that under massive capital outflow caused by economic sanctions, the informal market exchange rate overshoots the equilibrium stationary exchange rate, and the size of such overshooting depends on the size of available foreign exchange reserves held by the central bank.

Suggested Citation

  • Ibrahim A. Onour & Bruno S. Sergi, 2021. "The impact of a political shock on foreign exchange markets in a small and open economy: A dynamic modelling approach," Journal of Central Banking Theory and Practice, Central bank of Montenegro, vol. 10(3), pages 137-152.
    • Handle: RePEc:cbk:journl:v:10:y:2021:i:3:p:137-152
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    References listed on IDEAS

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    Cited by:

    1. Inda Mulaahmetović, 2022. "Quantitative Easing and Macroeconomic Performance in the United States," Journal of Central Banking Theory and Practice, Central bank of Montenegro, vol. 11(3), pages 79-98.

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    More about this item

    Keywords

    dynamic model; foreign exchange markets; political uncertainty; stability analysis; economic sanctions.;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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