The indeterminacy of a flexible exchange rate system when financial markets are dormant

Purpose – The purpose of this paper is to examine the extent to which a flexible exchange rate system is able to function given a least developed economy where financial markets are inactive and economic growth is low. Design/methodology/approach – A theoretical general equilibrium model is developed to examine the determinacy of a flexible exchange rate system on a small open market economy on the verge of subsistence. Using data from Sudan, an empirical analysis is conducted to find support for the theoretical results. Findings – The theoretical analysis finds that in economies on the verge of subsistence with inactive financial markets, a flexible exchange rate system is indeterminate and thus will not work. In support of the theoretical results, the empirical analysis indicates that the financial deepening of an economy has a significant positive impact on the determinacy of the exchange rate. Research limitations/implications – The robustness of the empirical results would be strengthened by examining the significance of financial deepening on exchange rates for additional economies with a large subsistence sector beyond Sudan. Practical implications – A policy recommendation for economies on the verge of subsistence such as Sudan is to develop their financial institutions in order to increase their competitiveness in the exchange rate market. Moreover, future empirical studies on the impact of exchange rate changes should include monetary variables in order to reflect the degree of an economy’s financial market advancement. Originality/value – The paper illustrates that under conditions of subsistence, general equilibrium models of devaluation are determinant only when supply functions are based on absolute prices and not relative prices.