In the 1970s, France had a dual exchange rate system in place for its residents. All business trade transactions took place at the official, or "commercial," exchange rate (say, 5 francs per U.S. dollar). All foreign investments by French industrial corporations were subject to prior government authorization. The regulation was even stricter for French financial institutions or private residents. They were not allowed to transfer currency abroad. French tourists could not take abroad more than FF 5,000 (or its equivalent in foreign currency) per year. French residents could buy foreign securities, but had to use a special "financial" rate to purchase these foreign currencies. Basically, the supply of foreign currency assigned to "financial" francs was fixed. To buy foreign securities, residents had to use the proceeds of the sales of foreign securities by other French residents. This led to a separate market for the "financial" franc with a different exchange rate. Foreign income and dividends paid were repatriated at the "commercial" franc rate and did not increase the supply of "financial" currency available. By contrast, foreigners were free to buy and sell French securities at the "commercial" rate, but they were not allowed to borrow francs.
a. Explain why this type of control imposed on French residents helps defend the French franc, which was periodically under devaluation pressure.
b. Would you expect the financial exchange rate to be higher or lower than the commercial rate?

Question

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The Answer is a. These controls made speculation against the French franc less attractive for residents. They would have to pay a premium if they wanted to buy foreign currencies, using a financial rate
that would be higher than the commercial rate. With the supply of foreign currency assigned to financial francs being fixed, there was indeed no possibility for any speculation against the French franc on the part of residents. On the other side, foreigner speculation strategies were reduced by the fact that they could not borrow francs.
b. The financial franc exchange rate (e.g., 6 francs per dollar) is likely to be higher than the commercial franc exchange rate (e.g., 5 francs per dollar). Controls make it difficult to buy foreign-currency securities and the supply of financial francs is fixed, while the demand for foreign investment grows over time with general growth. The difference between the two rates is likely to increase in periods where the franc is under speculative attacks.

In the 1970s, France Had a Dual Exchange Rate System