UNIVERSITY OF WASHINGTON
Department of Economics
Open Economy Macroeconomics Econ 472


Discuss how Mexico and Argentina managed their monetary policies from 1991
to 95. Clearly indicate the causes and effects of each shift in the IS and
LM curves.  Characterize and name the theoretical models that Argentina
and Mexico followed.

	Both countries tried to maintain price stability (low inflation).
One way to "commit' to price stability is to commit to a fixed exchange
rate regime (to " maintain the value of the currency in US Dollars," i.e.,
E = P* /P = $/Peso is fixed).  Why did Argentina succeed (at least until
no", and why did Mexico fail?

	The Argentines introduced a law where the monetary base must be
backed by international reserves. This is just a modern version of the
gold standard.       So Argentina is on the(Figure, I confirms this).
Barro tells us that variations
In reserves (and thus the money supply) have been closely related to the
variation in the BOP.

        When the Mexico crisis hit Latin America, and international
investors withdrew their funds from Latin American countries because of
fears of devaluations (see uncovered interest parity...the Argentine money
supply contracted (because reserves fell).  Now we have the classic
Mundell Income Specie Flow Adjustment.  Contraction of reserves equals the
contraction of the money supply, the interest rate rises, investment
declines and the economy moves into a recession,
(unemployment is currently at an all time high in Argent,;na).
       
	 Mexico also committed to a fixed exchane rate -- on paper, All
went well until November 1994 (see Figure 2).  Until then investors felt
bullish about the prospect-, of the Mexican Economy, for good reasons, the
central bank held very large international reserves, indicating that the
peso had good value.  The first big dip in reserves coincides with the
assassination of the presidential
candidate, but then reserves soar again to reach a peak in August.  Note
that the Monetary Base was entirely disjoint from changes in reserve,
indicating that the Mexican Central Bank sterilized changes in reserves.
    
     Finally, in the advent of the peso crisis in November 1994, reserves
declined drastically in Mexico, but instead of allowing the money supply
to contract the Central Bank sterilizes.  For good (short term) reasons,
Barro points out.  If the Central Bank had not sterilized, many of the
Mexican Banks would have gone bankrupt trying to pay out all the deposits
that foreigners now
wanted to relocate out of Mexico (The Argentinean Banking system is
currently in deep trouble).

         However, while the banking system was saved, reserves were
depleted to a degree that a fixed exchange rate could no longer be
credibly sustained. (I.e. if everyone was to exchange their pesos for $
the Central Bank would be bankrupt).  Immediately a run on the Peso
occurred forcing the Central Bank to devalue the Peso.

As of now, our model does not incorporate capital flows.  So, it looks
like Mexico is doing great after the devaluations.  But in fact they are
not.  Interest rates have risen to over 50 % (real) to stop the capital
outflow.

The crucial insight is that with sterilization the LM does not shift in
Mexico, but in Argentina, without sterilization the endogenous change in
Money Supply is responsible for the adjustment.