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The purpose of this paper is to analyse the two-tier exchange market in the context of a macroeconomic model that is more general than the traditional IS-LM framework. The latter is unsatisfactory from at least two points of view. First of all, it has been pointed out by McKinnon (1969) that short-term formulations are inconsistent with long-run equilibria if the government budget constraint is neglected. It should also be remarked that the introduction of the government balance constraint has implications for the short run: for instance, deficit-financed fiscal expansion is really a combination of higher government expenditures, a larger deficit and an increased stock of financial assets. Secondly, IS-LM analysis supposes perfect substitutability among all assets besides money. In recent years, the serious difficulties experienced by several European countries in achieving internal and external balance have given rise to an increased interest in two-tier exchange markets. At times, international capital flows have taken on amplitudes sufficient to disequilibrate the balance of payments of these countries and lead to inflationary or deflationary tendencies in their domestic markets. Some authors (Fleming, 1962; Mundell, 1962) have proposed the use of monetary policy tools in order to achieve equilibrium in the balance of payments. While it is true that manipulating the interest rate may, under certain circumstances, give satisfactory results, such policies have not been very successful in practice, and have led to conflicts with other policy aims. Other devices like the introduction of a two-tier exchange market may therefore be preferable. Consideration only of the overall balance of payments equilibrium neglects the very important question of its composition. A deficit in the capital account, for example, leaves domestic wealth unchanged (the increase in private claims on foreigners is counterbalanced by a loss in exchange reserves); whereas a deficit in the current account diminishes domestic wealth and, consequently, future earnings. It may therefore be appropriate to consider the current and capital accounts as independent targets of economic policy and to formulate two separate external aims: a desirable level of exchange reserves and a desirable level of foreign indebtness. The need for treating current and capital accounts as distinct targets is implicitly recognized by the advocates of the two-tier exchange system, although it can be only a second best solution.
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