Black Markets

Till now we have said that a central bank must intervene in the foreign exchange market whenever there is excess demand or supply of foreign currency. However, we might consider what would happen if the central bank did not intervene. Surely the government could simply mandate that all FOREX transactions take place at the official fixed rate and implement severe penalties if anyone is caught trading at a different rate. A black market arises, however, when transactions for foreign currency take place at an unofficial (or illegal) exchange rate.

Let’s consider why a black market may arise. Suppose the US fixes its exchange rate to the British pound at the rate Ē_$/£. This is indicated on the adjoining diagram as a horizontal line drawn at Ē_$/£. Suppose further that demand for pounds (Q₁) on the private FOREX exceeds supply (Q₂) at the official fixed exchange rate, but the central bank does not intervene to correct the imbalance. In this case, suppliers of pounds will come to the market with Q2 quantity of pounds, but many people who would like to buy pounds will not find a willing supplier. Those individuals and businesses demanding the excess, (Q₁ – Q₂) will leave the market empty-handed. Now if this were a one-time occurrence, the unsatisfied demand might be fulfilled in later days when excess supply of pounds comes to the market. However, a more likely scenario, is that this unsatisfied demand persists for a long period of time. And with each passing day of unsatisfied demand, total unsatisfied demand grows insidiously.

Together with the excess demand is a willingness to pay more than the official rate to obtain currency. Since the market equilibrium rate is at E_$/£¹, excess demanders would be willing to pay more dollars to obtain a pound than is required in the official market. The willingness to pay more creates a profit-making possibility. Suppose an individual or business obtains pounds, perhaps by selling goods in Britain and being paid in foreign currency. This person could convert the pounds for dollars at the official rate, or if he or she wants to make more money could trade the currency “unofficially” at a higher exchange rate. The only problem is finding someone willing to buy the pounds at the unofficial rate. This turns out rarely to be a problem. Wherever black markets develop, unofficial traders find each other on street corners, at hotels, and even within banks.

Thus a central bank doesn’t absolutely need to intervene in the FOREX market in a fixed exchange rate system. However, if it does not, a black market will very likely arise and the central bank will lose control of exchange rate. One main purpose of fixed exchange rates, namely the certainty of knowing what the currency will exchange for, is also lost since traders will have to decide whether to trade officially or unofficially. Furthermore, the black market exchange rate typically rises and falls with changes in supply and demand, thus one is never sure what that rate will be.

In light of the potential for black markets to arise, if a government wishes to maintain a credible fixed exchange rate, regular intervention to eliminate excess demand or supply of foreign currency is indeed required.

International Finance Theory and Policy - Chapter 80-9: Last Updated on 4/7/05