THE SHADOW EXCHANGE RATE

The shadow exchange rate or the shadow price of foreign exchange is required in the conventional approach to social cost-benefit analysis where goods are measured in domestic prices so that traded goods in foreign prices need to be converted into domestic prices, but not necessarily at the official exchange rate if there are distortions in the foreign exchange market and the official rate does not reflect the true opportunity cost of foreign exchange. The shadow price of foreign exchange may be written as:

P_F = ∑f_i [P^D / P^E]  ...         ...         ...         (14)

Where P^D is the domestic price of the ith import and P^E is the official exchange rate price of the  ith import and the fis are the weights reflecting the proportional importance of the commodity in the total import bill.