On the Effects of Regulation-Induced Forex Market Segmentation in Small Open Economies

The central banks of small open economies have to procure the proper operation of the payments system for transactions with the rest of the world. They do so facing the constraint of a limited stock of international reserves. To make ends meet, they usually rely on three instruments: the choice of an exchange rate regime, the regulation of the foreign exchange transactions of commercial banks and general exchange controls. Based on some stylized facts of the Mexican experience of the past three decades, this paper uses a Simulinkr model to show the effects of different institutional constructs on some key nominal variables. For a reasonable set of simulation parameters, it shows that either the complete segmentation of the peso-dollar market or a full integration of both markets are preferable to intermediate arrangements that contemplate some form of partial financial liberalization. ∗Instituto Tecnologico Autonomo de Mexico †Comments welcome