In these diagrams, contrast how Mexico and Argentina managed their monetary policy from 1991-1995. Clearly indicate the causes and effects of any shifts in the curves.

Characterize and name the Theoretical models that Argentina and Mexico seem to have followed.

The Wall Street Journal,

Monday, May 1, 1995
 

In the past several years, Argentina and Mexico have made major progress in economic reforms, notably in privatization, the structure of the public finances, and liberalization of foreign trade. The reforms were also supposed to include movement toward price stability, reinforced in each case by a commitment to maintain the value of the currency in U.S. dollars. In this context, Argentina has succeeded, while Mexico has failed.

For Argentina, the soundness of the currency is guaranteed by the convertibility law (one peso equals one U.S. dollar) and by the central bank’s charter, which requires full backing of the monetary base by international reserves. Some questions arise about the definition of these reserves, but the important point is that changes in the monetary base have been closely linked to the balance of payments. Thus, as seen in the chart on the left, movements in the base since 1991 have nearly matched the variations in international reserves. In this sense, the Argentine monetary system has functioned as a currency board.

A Commitment to Value

Speculative reactions to the Mexican financial crisis led to a sharp decline in Argentina’s reserves from December 1994 to March 1995 and to a one-quarter fall in the monetary base. This willingness to endure a severe monetary contraction underscored the government’s commitment to the value of its currency. The monetary contraction continued into April, and reversed only in response to growing confidence that the government was serious about maintaining the value of the peso (a view that was reinforced by loan commitments from international organizations and private banks). Ironically, the key element behind this confidence may be Argentina’s history of high and volatile inflation. In this environment, everyone knows that any devaluation would reduce the government’s credibility to zero.

Mexico’s reform plan also included a fixed exchange rate, but the government and the central bank never had a clear monetary policy to maintain this rate. The chart on the right shows that from early 1991 until November 1994—a period that includes the presidential election in August 1994—international reserves always exceeded the monetary base. (In the chart, the base has been converted from pesos into dollars at an exchange rate of 3.0, the value that applied in early 1991). But the relation between movements in reserves and changes in the base was nil, because the central bank engaged in offsetting operations to insulate domestic monetary conditions from the balance of payments.

Until November 1994, the divorce of the monetary base from international reserves was not necessarily inconsistent with the maintenance of a fixed exchange rate. Surplus reserves could be exchanged for domestic assets, and vice versa, but the reserves always provided full cover for the monetary base. In November and December, however, foreign investors lost confidence in Mexico’s commitment to a fixed exchange rate, and a run on international reserves ensued.

One negative element was the report on Nov. 23 of political involvement in the Ruiz Massieu assassination of Sept. 28. But more significant was the announcement on Nov. 30 of the new cabinet, notably the absence of Pedro Aspe, the key economic thinker of the outgoing government, and the presence of Jaime Serra as finance minister. This unfortunate change of personnel, followed in December by hesitation and vacillation on whether to devalue, convinced financial markets that the commitment to maintain the exchange rate was not serious.

Another key matter from late November through mid-December was the policy of the central bank. With reserves no longer in surplus, the fixed exchange rate could be guaranteed only if the plunge of reserves was matched by a decline in the monetary base (of the sort that occurred in Argentina from December 1994 to March 1995). Instead, the bank continued its policy of sterilization, so that the drop in foreign assets was balanced by a dramatic increase of domestic credit, not by a fall in the monetary base. As the chart on the right shows, one cannot detect from the behavior of the base after October 1994 that a financial crisis was going on.

As a technical matter, it is always feasible to peg the exchange rate if the central bank starts with reserves in excess of the monetary base, and if the bank pays out or receives reserves only in exchange for monetary base at the fixed rate. That is why a currency board fails only when the authority deviates from the rules.

Problems arise if the central bank tries to maintain not only the foreign currency value of its monetary liabilities but also the obligations of government and private banks. Specifically, the vast expansion of the central bank’s domestic credit after October 1994 appears to be an attempt to maintain the dollar value of government bonds and bank deposits; that is, to avoid increases in interest rates, as well as defaults by government and banks.

The central bank’s reserves were sufficient to cover the monetary base, but not nearly enough to match the sum of government bonds and broad monetary aggregates. Thus, once the financial markets reduced their dollar valuation of Mexican assets, the bank’s pursuit of this broader, unrealistic goal only encouraged the run on reserves by making devaluation inevitable. In the end, the desire to stabilize the dollar value of too many obligations led to a depreciation of anything that was fixed in peso terms.