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I was reading news articles about people in Venezuela and Iran getting a poor exchange rate for US dollars on the black market. Why do these people need to buy dollars? Why is it still worth while to buy dollars at an unfavorable black market rate? Why would Venezuela want to block the sale of dollars?

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migrated from economics.stackexchange.com Apr 28 '12 at 17:19

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A falling exchange rate is an indication of falling confidence in a currency. Countries like Iran or Venezuela, with a managed exchange rate, set their exchange rates at a higher value than the market accepts.

Such market expectations may be influenced by poor government management, interventions into markets (such as nationalising businesses) or general instability / scarcity. The governments act to manage that uncertainty by limiting the availability of foreign exchange and pegging the exchange rate.

Since there is an inadequate supply of trusted foreign currency people turn to informal exchanges in order to hedge their currency risk. This creates a negative feedback loop. People in government who have access to foreign exchange start to trade on informal markets, pocketing the difference in the official and unofficial rates. The increasing gap between the two rates drives increasing informal market exchange and can result in speculative bubbles.

Driving instability (or economic contradiction) is that the massive and increasing difference between the official and market exchange rates becomes a powerful form of rent for government officials. This drives further state-led rent-seeking behaviour and causes the economy to become even more unstable.

If you're interested in a more formal academic study of how such parallel markets in currency arise, "Zimbabwe’s Black Market for Foreign Exchange" by Albert Makochekanwa at the University of Pretoria is a useful source.

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Wow, great answer thanks! –  user5621 Jan 27 '12 at 18:52

The main reason people buy dollars (or other currency) on the black market is because they are prevented from exchanging currency on the official government market. Venezuela for example restricts citizens to a maximum number of dollars the citizen can buy or sell per year, depending on various factors such as whether or not the person is studying at a foreign university.

If the citizen wants to exchange more dollars than legally allowed, that person must buy or sell at the "black" market rate, rather than through the official/government market.

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