Terms of Trade, Commercial Policy, and the Parallel Market for Foreign Exchange: An Empirical Model of the Real Exchange Rate

A model of real exchange rate RER) determination is presented. The model permits long-run equilibrium movements in RER to be distinguished from its short-run disequilibrium dynamics. An important aspect of the model is that is explicitly considers the parallel market premium as one of the fundamental determinants of RER. Especially in economies plagued with persistent excess aggregate demand, and rapidly depreciating domestic currency under a regime characterized with currency inconvertibility and highly regulated current account transactions, the parallel market is usually a persistent and a growing part of the economy. The model is then applied to the case of the Sudan; which like many African countries, closely approximates the economic environments described above.